Consider Converting to a Roth IRA in 2010

In the past, you could convert your traditional IRA to a Roth IRA only if your income was under $100,000. But starting in 2010, that bar is gone. So if you have a traditional IRA, whose withdrawals will be taxed, you may want to seriously consider converting it to a Roth IRA and escape future taxes.

The first question is deciding if converting is a good idea. If it made sense before and you were unable to do so only because of the income limitation, the answer is probably yes. Switching gives you access to the benefits of Roth accounts. Those benefits include tax and penalty-free distributions, both of which generally kick in once you’re 59 and have met the five-year holding requirement.

In addition, Roth’s offer estate planning advantages. For example, unlike traditional IRAs, you’re not required to withdraw specified amounts from a Roth each year once you reach age 70. The same is true when your spouse inherits the account as your designated beneficiary.

 
The conversion to a Roth does have a cost. When you have no basis in your traditional IRA—for instance, you deducted your original contributions on prior tax returns—you’ll have to add the entire amount converted to your taxable income. That’s a reason to start planning now, since the increase in income could have tax and nontax implications, such as reducing itemized deductions or affecting college financial aid.

Fortunately, TIPRA provides a one-time incentive to make a traditional to Roth IRA conversion in 2010. The incentive works this way: You do not have to include the entire taxable portion of the conversion in your 2010 income. Instead you’re allowed to report half of the income on your 2011 tax return and the remaining half on your 2012 tax return. The deferral gives you a multi-year period to plan for, and pay, the tax.

On the other hand, you can choose to pay more quickly by making an election to report all of the conversion on your 2010 return. While prepaying seems counterintuitive, remember that present federal tax rates are set to expire December 31, 2010. Postponing income into future years could mean a bigger tax bill.

There’s another way tax rates can affect your decision about converting. Say you intend to relocate to a state with low or no income tax, and you expect the move to reduce your overall tax rate. In that case, you may decide to delay or forgo making a conversion.

The Roth conversion rules also allow you to “undo” a conversion. Put another way, you can reverse any Roth conversion as long as you do so before the tax filing becomes final for the year of the conversion. This makes sense when the value of your Roth declines substantially and the taxes you’d pay on the conversion become disproportionate to the Roth’s value. For example, if you converted in January 2010 and file an extension, you'll have until October 2011 (21 months) to reverse the conversion. In addition, you can also choose to convert a recharacterized IRA back to a Roth the following year, at a lower value and lower tax.

I’ve got one final tip. If your income in 2009 was more than $105K ($166K if married), you’re not eligible to make a regular 2009 Roth “contribution”. Your only option therefore is to make a contribution to a non deductible “traditional IRA”. However, since the $100K income threshold to convert to a Roth has been eliminated for 2010, you could subsequently convert your 2009 traditional IRA contribution into a Roth IRA this year and pay no taxes on the conversion since your basis (the amount of your contribution) will likely be equal to the amount you converted. It’s a nice little work around that essentially enables you to accomplish your goal of funding a Roth IRA.

To convert your 401K into a Roth IRA you must first make a direct rollover of your 401K into a traditional IRA. Once the funds are in your traditional IRA you can convert them to a Roth IRA.

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