If you thought about a Roth conversion early this year, it’s time to think about it again. Conditions have changed and you might want to reverse course and rushing to convert or perhaps to reverse a conversion that now seems unprofitable.
To rewind, the process involves moving assets from a traditional IRA to a Roth IRA. In a traditional IRA, or TIRA, you may or may not get a tax deduction on contributions, but investment gains are tax-deferred until withdrawal. At that point, gains and any previously untaxed contributions are taxed as ordinary income.
Roths offer no upfront deduction, but all contributions and investment gains are tax free when withdrawn. They offer other benefits as well, such as no minimum withdrawal requirement after age 70½ and better deals for heirs.
Upon converting, the investor pays income tax as with any TIRA withdrawal, but is not subject to the 10% early withdrawal penalty that otherwise applies when money is taken out before age 59½. Generally, a conversion makes sense if you expect to be in a higher income tax bracket in retirement than in the year of the conversion. By converting, you could pay the tax now to avoid a higher tax later.
Before 2010, conversions were available only to singles and couples with incomes below $100,000. That limit has been removed permanently, but there is a temporary tax benefit for conversions done in 2010: The investor can opt to split the tax bill between 2011 and 2012, or to pay it all in 2010. If you postpone the tax, you’ll pay at whatever rate is in effect in 2011 and 2012.
Current and future tax rates are therefore key factors in the decision as well. Unless Congress acts, the Bush era tax cuts will expire at the end of 2010, raising income tax rates next year. Back in January it was widely assumed, as it had been for years, that the cuts would be preserved for most taxpayers. Now the issue is up in the air.
If tax rates do rise, investors who plan to convert anyway may regret not doing so back in 2010 when rates were lower.
Investors who have already converted this year should look at their current account values to see whether the move was wise. Your tax bill is based on TIRA values at the time of the conversion. If your investments lost value afterward, the bill is higher than it could have been.
To fix the problem, you could do a “recharacterization” to reverse the process, changing your Roth back into a TIRA. Then you could think about converting again later. If you converted in 2010, you have until Oct. 15, 2011 to recharacterize. After recharacterizing, you have to wait at least 30 days to convert again.
There is still time this year, in other words, to recharacterize and then re-convert. That way you’d get rid of the high tax bill from the first conversion and end up converting your account at today’s reduced values. The taxable amount would be smaller and you’d get the 2010 income tax rate, which might be lower than the rate after Dec. 31.
Use the Banking My Way Roth IRA Conversion Calculator to explore your options. And remember a critical rule: To make a conversion worthwhile, you must pay the tax with money from outside the account.
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