This year, there is plenty of buzz over converting traditional individual retirement accounts to Roth IRAs, and rightfully so. This is the first year that higher income earners can convert to a Roth IRA and not have to pay taxes on the conversion until 2011 and 2012. That should make the decision to convert an easy one, right?
Think again. For some taxpayers, the conversion decision will make sense; for others, maybe not. This month, we will discuss some traps you should be aware of in making the election to convert your traditional IRA into a Roth IRA.
First, let's review the rules. Until 2010, if your adjusted gross income exceeded $100,000, you could not convert your traditional IRA to a Roth IRA. Starting in 2010, the income limitations are repealed. If you convert to a Roth IRA in 2010, you have the added benefit of reporting half the income from the conversion in 2011 and half in 2012. As discussed later, this might or might not be a good thing.
One thing to remember is that you are not necessarily locked into your decision. If you convert your traditional IRA now and by the end of 2010 or the due date of your return, the accountÂÂ’s value is down, then you can undo the conversion. In fact, you have until the due date of your 2010 return, including extensions, to decide whether you wish to stick with the conversion or revert to a traditional IRA.
Trap 1 - Tax rates can, and frequently do, change
At first glance, letting a taxpayer convert a traditional IRA to a Roth IRA and allowing the tax to be paid in 2011 and 2012 seems like a liberal rule. One problem with this scenario, however, is that we donÂÂ’t know what tax rates will be in 2011 and 2012. Many think the rates could be higher in the future to pay for current deficit spending. If thatÂÂ’s the case, deferring tax payments to 2011 and 2012 could be the wrong choice.
A second problem will be your adjusted gross income itself. With our progressive tax system, the higher your income, the higher your marginal tax bracket. Pushing income to 2011 and 2012 could put you in a higher bracket and cost you more money.
Ultimately, you will have to run the numbers and make assumptions about when you should report income from the conversion of your traditional IRA.
Trap 2 - Medicare costs
If you are currently on Medicare, you know that the cost of your premium increases with your income. The base monthly premium for Medicare B is currently $110.50 for most beneficiaries (Medicare A is still $0). If you increase your income above $85,000 (single) or $170,000 (married filing joint) by converting a traditional IRA, the premium starts to increase. This continues until income increases to over $214,000 (single) or $428,000 (married filing joint), at which point it maxes out at $353.60. For a couple filing jointly, this means a conversion could cost them nearly $6,000 extra in Medicare premiums if their Roth IRA is substantial.
Trap 3 - Financial aid
Most schools factor in a parentÂÂ’s income when considering a studentÂÂ’s eligibility for financial aid, though they do not count retirement assets. By converting to a Roth IRA, your income will be artificially inflated for the year(s) when you pay the conversion tax. This could negatively affect the financial aid your dependent might currently be entitled to.
Trap 4 - Market risk
As noted earlier in the article, the law allows you to recharacterize your conversion if it appears you have misread the market. In other words, if you convert a $250,000 traditional IRA and the value goes down to $150,000, it is not reasonable to pay tax on the $250,000. For this reason, Congress allows you to change your mind and undo your conversion.
One other method to minimize possible negative market fluctuations is to split your funds up among all the various asset classes. In theory, all asset classes are not likely to move the same, or at least not in equal percentage increases or decreases. By investing your IRA funds into multiple baskets, if one basket goes down, you can recharacterize it to the traditional IRA and leave the portions that increased in value in the Roth.
The preceding is a small list of potential traps that exist when converting from a traditional IRA to a Roth IRA. The process is fairly straightforward, but there are numerous calculations and recalculations you should run before you make your final decision. If you are considering converting all or part of your IRA, give us a call. We can help you make an informed decision.
Have a great month.