Client Bulletin 12-7-09:Liberalized IRA-to-Roth Conversions

For tax years beginning after 2009, the $100,000 modified adjusted gross income (AGI) limit on conversions of traditional IRAs to Roth IRAs is eliminated. Additionally, married taxpayers filing a separate return will be able to convert amounts in a traditional IRA into a Roth IRA.

A unique income inclusion rule will apply for IRA-to-Roth-IRA conversions occurring in 2010. Unless a taxpayer elects otherwise, none of the gross income from the conversion is included in income in 2010; half of the income resulting from the conversion will be includible in gross income in 2011 and the other half in 2012.

A major wild card in making this choice is the tax-rate picture after 2010. Absent Congressional action, after 2010 the tax brackets above the 15% bracket will revert to their pre-2001 levels. That means the top four brackets will be 39.6%, 36%, 31%, and 28%, instead of the current top four brackets of 35%, 33%, 28%, and 25%. The Administration has proposed to increase taxes only for those making $250,000 or more, but it is difficult to predict who will get hit by higher rates. What’s more, there are proposals on the table to help finance healthcare reform with a surtax on higher-income taxpayers.

It is always difficult to accept paying taxes today in return for lower taxes in the future, but we suggest that most taxpayers seriously consider the advantages of this opportunity next year, at least to some extent. However, in some cases, conversion to a Roth would not be the best recommendation. Each taxpayer is unique and this is why it is important to let us review your specific situation before any decision is made.

Taxpayers who intend to take advantage of the new Roth IRA conversion option next year should consider the following year-end strategies:

A) Non-high-income taxpayers who are able to make deductible IRA contributions this year should do so. They’ll reduce their 2009 tax bill and, if they make the conversion to Roth IRA next year, they won’t have to pay back the tax savings until 2011 and 2012.

B) High income taxpayers who haven’t made deductible IRA contributions in the past (or made a tax-free rollover from a qualified plan to an IRA) should consider making nondeductible IRA contributions this year. The conversion generally is taxable only to the extent of earnings on the nondeductible contributions. However, if the taxpayer previously made deductible IRA contributions, or rolled over qualified plan funds to an IRA, complex rules determine the taxable amount. That’s because all IRAs are treated as one for distribution purposes and then IRS rules govern what part of the converted amount is treated as a tax-free return of nondeductible contributions and what part is treated as taxable.

C) Some high-income taxpayers plan to make large conversions in 2010 but to opt out of the deferral of tax until 2011 and 2012 because they fear they will be in a higher tax bracket in those years than in 2010. These taxpayers should avoid the standard year-end-planning wisdom of accelerating deductions and deferring income but should rather do the reverse in an effort to avoid being pushed into the highest brackets by a large IRA-to-Roth-IRA conversion. These taxpayers should consider ways to defer deductions to 2010, and accelerate income from next year into 2009.