Start Planning Now for Your 2010 Roth IRA
Many people have wanted a Roth IRA, but didn’t meet the income limit guidelines. In 2010 this will no longer be an issue.
Beginning in 2010, the income limits on Roth IRA conversions that have prevented taxpayers with modified adjusted gross incomes of $100,000 or more to convert their traditional IRAs to Roth IRAs are lifted. Beginning January 1, anyone, regardless of income level, will be able to convert an IRA to a Roth IRA.
As with traditional IRAs, the assets inside a Roth IRA grow tax-free. Withdrawals from a traditional IRA are taxed as income to you when withdrawn. Withdrawals from a Roth IRA are completely tax-free as long as you’ve had the account for at least five years and you are at least 59-1/2 when you start to make withdrawals.
A big difference between Roth IRAs and traditional IRAs is that there is no requirement to take minimum distributions from a Roth IRA. Your beneficiaries will have to take minimum distributions, but they will be tax-free.
A conversion is treated as a taxable distribution, but is not subject to the 10-percent early withdrawal penalty. Generally, taxpayers must pay all of the income tax on the withdrawn amount in the year of the conversion. In 2010, and only for that year, taxpayers will be able to elect to pay the tax on the conversion over the next two years; that is, in 2011 and 2012. Conversions in subsequent years are included in income during the tax year in which the conversion is completed.
Deferring tax is usually a good idea, but keep in mind that the tax on your 2010 Roth conversion, if paid in 2011 and 2012, will be taxed at the rates in effect for 2011 and 2012. If income tax rates go up significantly, you could end up paying a lot more tax. If you do not want to risk it, you may elect to pay the full tax on the Roth conversion on your 2010 return at the 2010 rates.
You can’t convert to a Roth from a 401 (k) plan, but an IRA that is the recipient of a lump sum from a 401 (k) upon termination of employment can be converted. If your 401 (k) plan permits it, you could take an “in-service” distribution from the 401 (k), and roll all, or part, of the withdrawal into a Roth IRA.
Required minimum distributions (RMDs) cannot be converted to a Roth IRA, per se. But if liquidity is a problem, a RMD might be the solution. Remember, there is no requirement to take RMDs in 2009 (that was part of the stimulus package). You could take what would have been the required distribution and convert it in 2009 if the IRA owner qualifies under the $100,000 income eligibility limit for 2009. You could continue this plan in subsequent years until the traditional IRA is withdrawn in full.
Some taxpayers don’t qualify to make regular, deductible IRA contributions. Participation in an employer plan is the most common disqualifier. Even if you do not qualify to make deductible IRA contributions, there are ways to take advantage of the Roth IRA conversion. You could contribute to a nondeductible traditional IRA now, in anticipation of converting that traditional IRA to a Roth in 2010. These contributions would not generate a deduction now, but you would not pay any income tax on the conversion to a Roth IRA in 2010 to the extent that there was basis in the traditional IRA. In 2009, the maximum permitted contribution to a nondeductible IRA is $5,000 or $6,000 if you are age 50 or older at year-end. By starting in 2009, and making another contribution in 2010, you can effectively convert two years’ worth of contribution to a Roth IRA in 2010.
If you convert from a traditional IRA to a Roth IRA, and change your mind after the conversion, you have until October 15th of the year after the year of conversion to recharacterize the Roth conversion. That means reversing the Roth IRA conversion, and going back to a traditional IRA. If the market value of the Roth plummets after conversion, loss of value would be a good reason to recharacterize. If you correctly recharacterize the conversion, it rolls back the tax consequence as well, so you would recoup the tax paid on a much larger amount that was converted to the Roth.
2010 is the last year for the current income tax rates before they sunset in 2011. There may be a huge rush to do Roth conversions in 2010. Make sure you are prepared to take full advantage of the 2010 change in the law that eliminates the $100,000 income limit at the same time as historically low income tax rates are still available.
Start planning now to take advantage of this window of opportunity. Who knows how long it will be open.