Why would someone consider a conversion to a Roth IRA if there are tax consequences?
Because for many taxpayers, the current tax cost on a conversion will be overshadowed by potentially substantial tax savings in the future. The determination of whether a conversion should be made is quite involved, and because it involves projecting the future, it will be partially assumption based.
Only a person who is very knowledgeable about the tax law and about an individual’s particular family and tax situation should perform this analysis.
One factor to evaluate in determining whether a Roth conversion makes sense is the taxpayer’s current marginal tax rate and his or her expected marginal tax rates in the future. Obviously, predicting future tax rates is not something that can be done with precision; however, one can model various scenarios to determine the impact at varying tax rates. In general, if one predicts the taxpayer and/or his or her heirs will be in higher tax brackets in the future, it is more likely that conversion will be beneficial.
Another factor to consider is whether the taxpayer will be able to pay the taxes due on conversion with funds that are not in a retirement plan. The benefits of converting to a Roth IRA will be lessened if outside funds aren’t available to pay taxes due on conversion.
When does a taxpayer have to pay tax on the conversion?
For this year only, there is a special rule that takes the Roth conversion income and removes it from a taxpayer’s 2010 tax return and places half of the income in 2011 and the other half in 2012. Although this may sound like a great deal, it may not be because a taxpayer’s marginal tax rate may be higher in 2011 and 2012 than it is now.
Fortunately, taxpayers can opt out of this special rule if they wish and instead include all of their income in their 2010 tax return.
What if a taxpayer converts funds to a Roth IRA now and then his or her portfolio declines in value?
If the decline occurs prior to the extended due date of the tax return for the year of the conversion, the taxpayer can undo the conversion. For conversions in 2010, that would mean a taxpayer may have until Oct. 17, 2011, to decide what to do.
But the trustee must be alerted of the taxpayer’s desire to recharacterize the conversion. <<
Steven Y. Patler, JD, CPA, is a senior manager at Cendrowski Selecky PC. Reach him at (248) 540-5760 or [email protected].