Roth conversions have been getting a lot of publicity this year, for two reasons. First, 2010 is the first year that anyone can do them without being restricted by income limitations. Second, if you do a Roth conversion in 2010, you may report the income in 2010 or defer and spread it 50/50 in 2011 and 2012. 2010 is the only year this special defer/spread provision is available.
Briefly, when you make a contribution to a “traditional” IRA, you get a deduction but when you take a distribution, the amount is taxable. When you contribute to a Roth IRA you don’t get a deduction but distributions are tax free.
When you do a Roth conversion, it’s treated as if you take a distribution from your traditional IRA (taxable) and contribute it to a Roth. As such, the amount converted is taxable but it and any earnings after the conversion are tax-free when distributed.
In other words, do a conversion if your tax bracket will be low in 2010 or if you believe it will be low in 2011 and/or 2012, but recognize that despite their publicity, Roth conversions aren’t for everyone. Don’t do one if your tax rate is higher now than you believe it will be when you take distributions (generally, during retirement when you may have little other income). And remember the time value of money: paying tax now versus paying it later — or not at all — if you pass on the income to your children upon death.
CONVERSIONS – POST 2009
In taxable years beginning after December 31, 2009, the AGI limitation that prevented many taxpayers from converting traditional IRS is eliminated.
In addition, there is a one-time bonus in the law regarding income recognition. The taxpayer who makes a conversion in 2010 may recognize all the income in 2010 or spread the income over the next two years. The wording of the law is a bit odd: “. . . shall be so included ratably over the two-taxable-year period beginning with the first taxable year beginning in 2011.”
What this means is that if a taxpayer makes the conversion in 2010, he or she recognizes half the income in 2011 and half in 2012. Alternatively, the taxpayer may elect to recognize all of the income in the 2010 year of conversion.
One-time opportunity: If making a conversion in a year after 2010, the taxpayer recognizes all the income in the year of conversion.
California Conformity:
California conforms to these provisions. However, a taxpayer may make a separate election on when to report the conversion. The taxpayer may elect to report all the income to California in 2010 or ratably in 2011 and 2012, independent of the federal election.
Example of 2010 conversion:
In 2010, Irene converts her traditional IRA worth $10,000 to a Roth (she has no basis in her IRA). She may recognize $5,000 in 2011 and $5,000 in 2012. She may, however, elect to recognize the full $10,000 in 2010. If she makes the conversion in 2011, she must recognize the entire $10,000 in 2011.
MFS now eligible: Another change beginning in 2010 is that married taxpayers filing separate returns may now do Roth conversions.
Two-year deferral is the default:
Income recognition from a 2010 conversion will take place in 2011 and 2012 unless the taxpayer elects to report all of the income in 2010.
Can I amend?
Wouldn’t it be nice if we could choose one or the other – report the conversion in 2011 and 2012 or report it all in 2010 – and amend later when we know the client’s tax situation for each of those three years? After all, the general statute of limitations is three years, which would mean we’d have until April 15, 2013, to make our final decision. Unfortunately, we don’t have that option. IRC Sec 408A(d)(3)(A) provides in plain language:
Any election under clause (iii) for any distributions during a taxable year may not be changed after the due date for such taxable year.
Thus, it would appear that you can amend, but no later than the extended due date of the return (10/15/11).
Can I do both?
Can you elect to report some of the conversion in 2010 and spread the rest over 2011 and 2012? Generally, no. Both the two-year spread and the election are contained in IRC Sec 408A(d)(3)(A)(iii), which states, “unless the taxpayer elects not to have this clause apply . . .” As such, the choice is all or nothing.
It would seem that a taxpayer could not get around that result by converting multiple accounts. First, the IRC makes it clear that the taxpayer has a choice to make the relevant clause apply or not. Second, the IRS did not allow splitting treatment when 1998 conversions were allowed a four-year spread with an election out.
Joint return strategy: In the case of a joint return, there is nothing to prevent once spouse from converting his or her IRA and electing 2010 treatment, and the other from spreading over 2011 and 2012.
Taxpayer dies
If the taxpayer does a conversion and dies, the entire unreported amount is reported in the year of death. As such, if a taxpayer does a conversion in 2010 and dies in 2011, the entire amount of the conversion is recognized in 2011 (assuming the taxpayer did not elect to report income in 2010).
Important caveat
Before implementing this strategy, keep in mind the following: Under distribution rules, all of the taxpayer’s IRAs are combined. This can lead to undesirable results for a high income taxpayer.
Example: Steve makes nondeductible contributions totaling $22,000 in the years 2006 through 2009. He has no other IRA accounts. In 2010, when Steve’s IRA has a value of $26,000, he converts it to a Roth. Unless he elects otherwise, Steve will report no income in 2010, $2,000 in 2011, and the remaining $2,000 in 2012. Or, he may elect to recognize the entire $4,000 “gain” in 2010.
However, suppose in his younger years, he had made deductible IRA contributions. Those accounts now have a combined value of $74,000, bringing the total value of his IRA accounts to $100,000 ($74,000 + $26,000). He converts the account that holds the $26,000 in 2010. In this case, he may only use 22% of his IRA basis ($22,000 divided by $100,000). As such, he uses basis of $4,840 (22% X $22,000). His taxable amount is $21,160 ($26,000 - $4,840).
Conversion Planning—Generally
Contributing to a Roth IRA can be a no-brainer for an individual nearing retirement age with a few extra dollars to save. But does that same taxpayer benefit from a Roth conversion? Sometimes, yes, and sometimes, no. Consider such issues as tax bracket, income fluctuation, and estate tax when making the decision to convert a traditional IRA to a Roth IRA.
Individuals nearing retirement are often in the top tax bracket. If an individual will drop to a lower bracket in the next few years, paying the tax on the Roth conversion now may not compensate for tax-free income later.
But, if a taxpayer currently has a low income year, consider converting the traditional IRA to a Roth. Taxpayers with large business losses, net operating losses (NOLs), or large itemized deductions combined with low income are also good candidates.
NOL opportunity
When a taxpayer has a NOL, itemized deductions and personal exemptions often go unused. This is the perfect opportunity to convert all or a portion of a traditional IRA to a Roth IRA. Estimate how much can be converted without creating taxable income. Converting too much will result in taxable income at the lowest tax bracket. Converting too little will waste those personal deductions
Example of NOL
Terry has a $100,000 NOL carried forward from the prior year. His current AGI is $5,000 after applying the NOL. Terry’s itemized deductions and personal exemptions will be $20,000. Terry should convert at least $15,000 from traditional IRA to a Roth. This will bring his taxable income to zero.
Using charitable contributions
The charitable contribution deduction is limited by federal AGI. For most contributions, the law limits your deduction for charitable contributions to no more than 50% of AGI. Unused contributions may be carried over for five years before they expire. If a taxpayer is in danger of losing charitable contribution carryovers, doing a Roth conversion will
- · Increase AGI;
- · Increase charitable contributions by 50% of the AGI increase; and
- · Increase taxable income by only 50% of the amount of the conversion.
The net effect of this plan is to cut the tax on the Roth conversion in half.
Effects of increased AGI on passive losses and Social Security taxability
The increase in AGI caused by Roth conversions can have negative tax consequences due to the phase-out of the $25,000 passive loss allowance on AGIs in excess of $100,000, and on the taxability of Social Security benefits for AGIs in excess of certain thresholds.
Cash outside the IRA to pay for the tax obligation
Assuming that you don’t have an NOL or other tax break to completely wipe out the income on the conversion, the taxpayer is going to need cash outside the IRA to pay tax on the conversion.
Conversion Planning—Recharacterization (the “Mulligan”)
If having excess deductions is the number one reason to do a conversion, the other number one reason to do a conversion is the “mulligan,” or the “do-over.” In the world or Roth conversions, the mulligan is the “recharacterization.” You make a conversion that you regret, so you recharacterize the conversion. Now you get to pretend that the conversion never happened.
What makes the IRA mulligan so inviting is that the deadline for making it isn’t until the extended due date of the return for the year of the conversion. This is true even if you don’t extend the return.
This means that if you do the conversion on January 1, 2010, you have until October 15, 2011 to decide if you really meant it.
Recharacterizing a high-value conversion to a Roth
When the taxpayer’s IRA consists of stocks and mutual funds, the lowest tax cost to the taxpayer is when a conversion is made at the time the market is at its lowest point since the taxable amount of the conversion is based on fair market value.
A taxpayer who converts from a traditional IRA to a Roth when the market is high will have an artificially high tax bill. If the market drops, the taxpayer may treat the conversion as if it had never been made by recharacterizing it. The taxpayer may later do the traditional-to-Roth conversion when the market is lower and therefore so is the tax cost.
Break into multiple Roths
Most account owners hold their IRAs with diversified portfolios in order to smooth out gains and losses. De-diversifying accomplishes the opposite—it accentuates gains and losses.
If you hold five stocks in your IRA, the probability that at least one of them will gain more than the average of the five is 100% (unless all five gain exactly the same). Thankfully, you can break out the five stocks in the single IRA and do five separate conversions into five separate Roth IRAs. If just one of the five appreciates substantially by the extended due date and the other four remain flat or decline, you can allow that one conversion to go through and recharacterize the other four.
Keep in mind that if you roll funds from a traditional IRA into an existing Roth that has a balance, then you must aggregate the gains and losses on all the assets in the account for the current year. This could diminish the tax benefits of recharacterizing. For the same reason, gains and losses will have to be aggregated if multiple assets are rolled into or acquired within a single Roth, even if the Roth is new.
Example of multiple accounts: Michelle converts $100,000 from her traditional IRA into a Roth. She uses the funds to buy $50,000 of Generic Stock and $50,000 of Plain Stock. By her extended deadline, Generic has gone up in value to $100,000 and Plain has gone down in value to $0. Michelle will have to recognize $100,000 of income if she allows the conversion to go through.
Kat does the same as Michelle, except she uses two separate Roths for the two stocks. Kat can let the conversion holding the Generic stock go through and recharacterize the Roth holding the Plain stock. She will recognize $50,000 of income.
Kat only has to recognize half as much income as Michelle even though their Roth IRAs have equal value.
Tuesday, November 27, 2012 at 12:49PM 