Year-End Tax Trusted Advice Planning for IRAs

 In Retirement, Taxes

Most years don’t require much year-end planning for IRAs. You have until the following April 15 to make “look back” contributions. For example, you can contribute to a traditional IRA or a Roth IRA for 2010 any time until April 15, 2011.

This year, however, is not like most years. As part of your year-end planning, you may want to convert all or part of your traditional IRA to a Roth IRA. Indeed, you might want to make a 2010 traditional IRA contribution before year-end in order to have more money available for a 2010 Roth IRA conversion.

Roth IRA rewards
When you convert a traditional IRA to a Roth IRA, you will owe income tax. Why pay tax that you might be able to defer for many years? Because you can withdraw any or all of the money in your Roth IRA, tax-free, after five years and age 59½. Paying tax now can provide years of tax-free future growth.

What’s more, you never have to take required minimum distributions from a Roth IRA. When you pass the age 59½ and 5-year marks, you can withdraw tax-free cash, as needed. If you need little or no cash from your IRA, you can leave the account alone, continuing the tax-free growth for yourself or for your Roth IRA beneficiaries.

Timely tactics
You can get the advantages of a Roth IRA by converting at any time. However, there may be special reasons to convert this year: Low tax rates. Income tax rates are now scheduled to increase in 2011. By converting in 2010, you can use this year’s relatively low tax rates. If your taxable income is generally $200,000 or more, you might be particularly interested in a 2010 Roth IRA conversion. The Obama Administration has proposed increasing tax rates only for such high-income taxpayers. (As of 2010, you can convert a traditional IRA to a Roth IRA even if you have a six- or seven-figure income.)

Tax deferral opportunity. Roth IRA conversions in 2010 get a unique tax benefit. You can choose to pay the conversion tax on your 2011 and 2012 tax returns. If you make this choice, you will split evenly the taxable income between those two years.

With all Roth IRA conversions, including those in 2010, you can recharacterize (reverse) all or part of the transaction back to a traditional IRA by October 15 of the following year. Therefore, you’ll have a chance for savvy tax planning with a late 2010 Roth IRA conversion.

Example 1: Mark Palmer has $100,000 in his traditional IRA. All of those dollars are pretax from deductible contributions. Therefore, a Roth IRA conversion will be 100% taxable. In December 2010, Mark converts the entire account to a Roth IRA.

In April 2011, Mark reviews his Roth IRA conversion. He is in the 28% tax bracket for 2010; he now learns that the 28% tax bracket was not increased for 2011. Therefore, Mark decides that he will keep his Roth IRA conversion in place and defer the income tax. Mark will report $50,000 of taxable income from the Roth IRA conversion on his 2011 tax return and the remaining $50,000 on his 2012 tax return. In his 28% tax bracket, Mark will owe $14,000 in Roth IRA conversion tax on his 2011 tax return. If tax rates and Mark’s income tax bracket remain the same, he will owe another $14,000 on his 2012 tax return.

Example 2: Assume the same facts as example 1, except that Mark does not want to pay $28,000 in total tax on a Roth IRA conversion, even with the tax deferral. In his specific financial situation, Mark wants to pay no more than $20,000 in total tax.

To keep the example simple, assume Mark’s Roth IRA is still worth $100,000 in April 2011. Mark recharacterizes $30,000 of his Roth IRA to a traditional IRA, leaving him with a $70,000 conversion. Mark can choose to report $35,000 of that income in 2011 and the other $35,000 in 2012. If Mark is in the 28% tax bracket both years, he will pay a total of $19,600 in Roth IRA conversion tax: 28% × $70,000.

Example 3: Suppose, however, that current law remains in effect and the 28% tax rate increases to 31% for 2011. In this scenario, Mark decides to pay the tax on his 2010 tax return to use the 28% bracket. He can implement a full $100,000 conversion and pay $28,000 in tax. Alternatively, if he decides he’d rather pay $19,600 in tax, Mark can recharacterize $30,000 of his Roth IRA conversion. Then he can report a $70,000 Roth IRA conversion on his 2010 return and pay $19,600 in tax, at the 28% rate.

Traditional IRA, too
In 2010, you can contribute up to $5,000 to a Roth IRA or a traditional IRA (up to $6,000 if you’re 50 or older by year-end). If you usually contribute to a traditional IRA, you might consider making that contribution well before December 31, 2010. That will give you as much as $6,000 more in your traditional IRA that can be converted to a Roth IRA in 2010.