New Roth IRA Conversion Rules in 2010

If you have been unable to open a Roth IRA because of IRS income limits, you will have an opportunity to convert your traditional IRA into a Roth IRA starting in 2010. The $100,000 modified adjusted gross income limit that prevented conversions and rollovers to Roth IRAs by some workers has been lifted beginning this year. The IRS is also providing an incentive to act quickly by offering taxpayers an opportunity to postpone payment of income taxes due to the conversion, allowing half to be paid in 2011 and half in 2012.

You will have to look at your own financial situation to determine if you should convert a traditional IRA to a Roth IRA and if so, the best way to pay the taxes.

There are some very compelling reasons to have a Roth IRA. Although contributions to a Roth IRA are made in after-tax dollars, all of the earnings can be withdrawn tax-free after age 59½ provided that the Roth IRA is open for a least five years. In addition, the rules requiring minimum distributions from traditional IRAs beginning at age 70½ do not apply to Roth IRAs. As a result, a Roth IRA can be used to pass tax-free income to the owner’s heirs. And unlike distributions from traditional IRAs, qualified Roth IRA distributions do not add taxable income, which means the taxpayer’s tax bracket, itemized deductions, and taxes on social security benefits are not affected.

At the same tax and earnings rates, equal contributions to both types of IRAs should result in the same net retirement savings. If you believe your tax rates will be lower when you take distributions, you might want to stay with a traditional IRA. If you think they will be higher – and you have some time until you have to use the money, or if you do not plan to use the money but to pass it on to your heirs – the Roth IRA may be the better alternative.

A pivotal question is whether you have the cash to pay the tax on the converted amount. If you have to take funds from the IRA itself, thereby reducing the amount left in the IRA, it may not be a wise decision. And if you are under age 59½, you will incur a 10% premature distribution penalty on all amounts you do not roll over.

If you do have the cash to pay the tax on the conversion, you will have to decide whether to pay it in 2010 when you convert your traditional IRA, or spread it over the next two years. Normally, deferral of taxes is preferable, but if Congress does not act, tax rates are scheduled to rise to pre-2001 levels in 2011. In that event, the taxes will be higher in 2011 and 2012, and it will be more expensive to wait than to pay the entire tax at 2010’s lower level.

Incidentally, the new conversion rules do not apply to new Roth IRA contributions, which are still subject to income eligibility limits.

Claudia Allen is a partner in the firm’s Tax Department. She regularly practices in the area of benefits and tax planning. If you have any questions about IRA issues, please call Claudia directly at 513-629-9462.