A client recently asked me about converting a traditional IRA to a Roth IRA. As I was researching the issue and writing my response (which, I’ll admit, snow-balled on me…), I thought you might also be interested in my explanation of this great tax savings and financial planning opportunity.
Beginning in 2010, there is a loophole in the tax code regarding IRAs. A brief background on the two most common types of IRAs:
Traditional IRAs: Contributions are often tax-deductible, all transactions and earnings within the IRA have no tax impact (earnings inside the IRA are not subject to tax), but withdrawals at retirement ARE taxed as income.
Roth IRAs: Contributions are not tax-deductible, all transactions within the IRA have no tax impact (earnings inside the IRA are not subject to tax), and withdrawals are NOT usually taxed as income.
Please note that there are income level ceilings and contribution limits on both types of IRAs. For the sake of keeping this email relatively straight forward, I’m not going to discuss those limits at this time.
Prior to January 1, 2010, anyone with annual income over $100,000 could not convert a traditional IRA to a Roth IRA. This meant that these individuals could not convert their traditional IRA to take advantage of the long-term tax savings provided by a Roth IRA.
THE LOOPHOLE: During 2010, the $100,000 income ceiling has been eliminated. This means that anyone can now roll-over a traditional IRA to a Roth IRA regardless of his or her income level. As noted above, the benefits are that the growth inside the Roth IRA over the next 20 or 30 years would occur tax free and the qualified distributions (e.g. after age 59 1/2) would also be tax free. To the contrary, if the funds remained in the traditional IRA, they would continue to grow tax-free, but would be fully taxable upon distribution. The downside is that a portion of the roll-over amount may be subject to tax. How much of this roll-over amount is taxable at the time of conversion depends on the character of your past contributions.
If your past contributions to the traditional IRA were non-tax deductible (the contributions were not deducted from your gross income prior to tax being withheld from your paycheck) then only the income earned on those non-tax deductible contributions would be subject to tax at the time of conversion.
If your past contributions to the traditional IRA were tax deductible (or, “pre-tax”), then the entire amount of the roll-over would be taxable at the time of conversion.
You may be asking yourself, why would anyone intentionally cause themselves to suffer a taxable event? The answer is that the taxable amount at the time of a conversion during 2010 would be, by design, substantially less than the taxable amount available for distribution from your traditional IRA after 20 or 30 years of growth. By making the conversion during 2010, you will save yourself a significant amount of money over your lifetime.
Finally, there is a special rule in place for 2010 only, which serves as an additional incentive to making this conversion this year. This special rule allows you to either recognize 100% of the conversion income in 2010 or split the recognition of the income equally between the next two tax years (2011 and 2012). With proper planning, your tax liability from such a conversion can be greatly mitigated.