Converting to a Roth IRA in 2010

Starting in 2010, individuals can convert their traditional IRAs into Roth IRAs with fewer restrictions. Prior to 2010, an individual could convert a traditional IRA (or eligible rollover distribution) to a Roth IRA only if the taxpayer had modified AGI of $100,000 or less. Married taxpayers filing separate returns were also prohibited from making a conversion. As of January 1, 2010, there are no longer any income or filing status restrictions on conversions. Any taxpayer can convert assets to a Roth IRA.

Roth IRAs provide income tax benefits that are not available within traditional IRAs. They are easy to set up and are often used for estate planning and asset retention. Unlike a traditional IRA, distributions from a Roth IRA are not taxable (assuming certain conditions are met). The different treatment related to distributions can be a strong incentive when establishing a Roth IRA.

While there are many reasons to convert a traditional IRA to a Roth IRA, the primary advantages are:

• no tax is owed on a qualified distribution from a Roth IRA. The tax-free treatment is also available to post-death beneficiaries;
• no required minimum distributions (except to a post-death beneficiary);
• no age limit on setting up the IRA or making contributions (a traditional IRA cannot be set up or contributed to after the owner reaches age 70 1/2); and
• no income inclusion. Because a qualified distribution is not included in income, the recipient’s AGI is less, reducing the threshold for certain itemized deductions and avoiding any effect on the potential taxation of Social Security benefits.

Taxation of Conversions

The conversion of a traditional IRA to a Roth is not tax-free. A conversion is treated as a distribution of all of the assets in the traditional IRA. Although the penalty on early distributions generally does not apply, the entire distribution must be included in current income, unless the traditional IRA includes nondeductible contributions.

Recharacterization

Recharacterization gives some wiggle room to an individual who is unsure whether to convert. An individual who later has second thoughts can recharacterize the Roth IRA as a traditional IRA. For the recharacterization, a taxpayer has until the due date, with extensions, for Form 1040 (generally October 15). A conversion in 2010 can be reversed through October 17, 2011. The ability to recharacterize is good insurance in case the Roth IRA’s assets decline in value after conversion.

Conclusion

While the downturn in the market triggered steep losses for many investors, the decline in the value of traditional IRAs makes conversion less expensive. Taxpayers considering conversion should do it sooner rather than later so that subsequent market gains can accrue tax-free in the Roth IRA rather than be taxed on a later conversion. Taxpayers who can pay the taxes due on conversion out of other assets will be able to maintain the value in their IRA and build up more tax-free earnings. Taxpayers who are close to retiring and drawing on their traditional IRAs may not find it worthwhile to convert the IRA, but younger taxpayers will benefit from a conversion because the longer period until retirement will allow the Roth IRA’s earnings to build up.

Taxpayers need to evaluate the advantages of a Roth IRA over a traditional IRA and compare them to the disadvantages of a taxable conversion.