2010 Tax Law Changes Impact IRA Owners - Hilton Head Monthly, September 2009

It’s not too early to prepare for 2010, when an important change in IRA regulations regarding Roth IRAs goes into effect for high income investors.

Beginning in 2010, the $100,000 modified adjusted gross income limit, or MAGI, limiting conversion of funds from traditional IRAs to Roth IRAs, is waived. This presents an opportunity for thousands of investors whose income eliminated them from even considering a Roth conversion. In addition, as an added incentive to convert in 2010, the taxable income resulting from a Roth conversion (in 2010 only), can be spread out over two tax years, 2010 (paid by 4/15/2010) and 2011 (paid by 4/15/2012).

Why Convert Your IRA?

Why convert in the first place? Well, the advantages of a Roth IRA can be compelling. The Roth is funded with after tax dollars, and all future growth can be withdrawn completely tax free. This makes a Roth a superb home for your more growth oriented investments, particularly those that still have some way to go to recover their previous value. If they recover in the Roth, the gain is tax free.

Additionally, unlike a traditional IRA, a Roth is not subject to required minimum distributions at age 70 ½. A spousal beneficiary can take over a Roth IRA, make it their own, and allow it to continue to grow. Only when a non-spousal beneficiary inherits the account are distributions required, and then only over the life expectancy of the beneficiary. The implications of having, say, a grandchild as a Roth beneficiary can be staggering. Finally, a Roth IRA gives you a lifetime shelter from taxes, no matter how high the tax rates might rise in the future.

Factors to Consider in Roth Conversions

However, a Roth conversion in 2010 is not necessarily the best strategy, even if your income has precluded you from considering a Roth rollover in the past. First, consider your present and future tax bracket. If you think your tax bracket will fall significantly, you may be better off leaving your IRA alone and paying the taxes on the money as you withdraw it.

Second, how you will pay the additional conversion related tax? A conversion probably won’t make sense unless you have money outside your IRAs to pay the tax bill. If you withdraw from the IRA to pay the tax you’ll be taxed on the withdrawals, and may be subject to a 10% penalty if you're under 591/2.

Time is also an important factor. In general, the longer you have until you plan to withdraw your earnings tax-free from the Roth, the better the numbers will look.

Remember, the additional income resulting from a Roth conversion may increase the taxable portion of your Social Security, and may lower or eliminate your ability to take certain income related itemized deductions as well. When evaluating the benefits, be sure to include the present value of the funds you use to pay the taxes on conversion; you would have had this money and all its growth if you didn’t convert.

Here’s an example based upon 2009 tax rates. Your adjusted gross income in 2010 is slightly over $100,000, and you are now eligible to make a $70,0000 Roth conversion. Normally, the $70,000 additional income due to the conversion would be taxed as follows: 25% incremental tax on $37,050, and 28% tax on the remaining $32,950. However, since you are able to spread the additional $70,000 of conversion related income over 2010 and 2011, you will only pay a 25% rate on the $32,950, rather than the 28% rate had you recognized the income in a single year.

There can be estate tax advantages to a Roth conversion as well. When you pay the conversion tax, you effectively prepay income taxes for your heirs without owing any gift tax or using up any of your valuable estate-tax exemption ($3.5 million for 2009). Prepaying the income taxes reduces the size of your taxable estate.

Preparing for 2010

You can get started by doing some necessary research on your IRAs and eligible 401(k)s. Be sure to identify any accounts that have both pre-tax and after tax money. Examine strategies to reduce taxable income as much as possible in the year of conversion, or 2010. It may make sense for some investors, especially those who have had their required minimum distributions, or RMDs, waived in 2009, to take out additional funds and plan to spend them in 2010, to lower that years taxable income. Remember, the waiver of required minimum distributions is for one year only, and you cannot convert your RMD to a Roth, even in 2010. We recommend that you have a pro-forma tax projection done for 2010 and 2011, based upon your last tax filing, so you see the total tax implication of the conversion. Spend some time with your CPA or tax advisor on the numbers.

Remember, even if you don’t get it right, the IRS will allow you to undo, or recharacterize, a Roth conversion. You can recharacterize a conversion anytime up to the income tax filing deadline for the tax year of your conversion, including extensions. So if you converted in 2010, you can undo it as late as Oct. 15, 2011. However, If you want to roll your account into a Roth again, you must wait at least until the year after your original conversion (2011 or later if you converted in 2010), and your second conversion must be at least 31 days after your recharacterization.

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