Written By Tom Anderson
Last week I discussed who might consider converting their traditional IRA to a Roth IRA, and thereby take advantage of the unique opportunity that is available this year only, to defer the tax impact of the conversion until 2011 and 2012 tax years. This week, I’m going to outline some strategies you can use to make the most of a 2010 conversion.
First of all, if you haven’t already made your traditional IRA contribution for 2009, you have until April 15th to do so. If you are not eligible for a deduction for your contribution because you exceed the compensation limits (your deductible amount begins to phase out if your filing status is married filing jointly and your AGI is more than $89,000 but less than $109,000. If your filing status is single, or head of household the deductible amount begins to phase out if your AGI is more than $55,000 but less than $66,000. Or if your filing status is married filing separate returns your deductible phase out starts at under $10,000. Thus, if you exceed the appropriate amounts of income for your filing status, you will not be able to claim a deduction). If it turns out that you are not able to claim a deduction, you will be eligible to convert the amount of your contribution (up to $6,000 in 2009 (if you are over 50, or $5,000 if not), to a Roth IRA tax-free. However, if there are any earnings between the time you contribute to the traditional IRA and the time you convert to the Roth, they will be taxable.
By the way, any prior year non-deductible contribution amounts can also be converted tax-free, exclusive of earnings.
Secondly, depending on the mix of assets in your retirement portfolio, you may want to convert one or more IRAs or plans, or certain assets within theses accounts, into separate Roth IRAs. That’s because you may need to reverse one or more conversions back to traditional IRAs (called recharacterizations) and having more than one Roth IRA to choose from can allow you to choose the losing Roth (e.g., containing asset(s) that may have depreciated since conversion) from those Roths and investments that are doing better than others. In doing so, your winners will continue to grow tax-free. You also avoid having to pay tax at a higher value at the time of conversion for an asset that later depreciates before the deadline for a recharacterization (up to October 15, 2011 which is your deadline with a tax foiling extension).
Also, you should avoid combining converted amounts with Roths formed in prior years, because if you ever need to recharacterize, the calculations (which need to be prorated) can be complex and not necessarily to your advantage.
Another strategy is to consider converting only a portion of your traditional IRA or pension plan, because you may have one or more depreciated assets that are likely to appreciate in the future. Converting the assets before they appreciate will save you on taxes that would apply if you were to convert them after they appreciated. Also, the overall tax burden may be too high for you if you convert all of your traditional IRA(s) in one year.
Bear in mind that there is a five-year rule associated with Roth distributions following a conversion. Any distribution during the five-year period starting on January 1st of the year of your conversion, will be subject to a 10% penalty on the entire amount of the conversion (not distribution), unless the distribution is made after age 59.5 or another exception applies. Also, if the individual who spread out the income inclusion over 2011 and 2012 dies before 2012, the deferred amount is includable in the year of death, unless the spouse acquires the deferred amount. The moral to this story is don’t die before 2012 if you want the maximum benefit of a conversion to a Roth IRA!
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