More Planning Tips for IRA Conversions
We covered a lot of ground on IRA conversions in recent visits. We’ve been thorough but there are a few more angles that you should consider before deciding whether to convert a traditional IRA to a Roth IRA.
Early is Best
You can convert your traditional IRA to a Roth IRA any time during the year, but you’ll probably have the best results by converting early in the year.
When you convert early, the positive returns and income for the year all will be in the Roth IRA. Delay the conversion, and the income and gains will be part of the conversion. You’ll pay taxes to convert them to the Roth IRA. The greater the income and gains earned in the Roth IRA, the greater the payoff is from converting.
Suppose you convert early and the IRA loses money after the conversion. That’s no problem. The conversion can be reversed. There’s no risk to doing the conversion early, because you can monitor the Roth IRA and decide to reverse the conversion when it makes sense. We review reversals (known as recharacterizations) in a future visit.
Extend Your Return
A conversion can be reversed any time up until the deadline for filing your tax return for the year, including automatic extensions, if you file your tax return on time. For example, if you convert in 2010, you have until Oct. 15, 2011 to reverse the conversion. If you fail to file on time, however, the deadline for reversing the conversion is the date you file the return.
You can monitor the IRA until the deadline for a recharacterization. Should its value decline to less than the value at conversion, you can do a recharacterization. You probably don’t want to pay taxes on a value that is above the current level, unless you anticipate a rebound soon.
I recommend you file for an automatic extension of the return filing deadline to Oct. 15 for the year of the conversion. You don’t have to, but it probably will make everything easier. You still have to pay your taxes on time. The deadline is easily extended automatically by filing Form 4868 by the April 15 filing deadline.
Not Just for IRAs
The conversion opportunity is not just for IRAs. Now, almost any qualified retirement plan can be converted directly into a Roth IRA, including 401(k) accounts. You have to meet any conditions your plan has for rolling over an account. Many plans require you to either leave the employer or be over age 59½.
Should You Defer the Taxes?
For conversions done in 2010, you have a choice of when to pay the taxes. You can include the entire converted amount in gross income in 2010 and pay all the taxes that year. Or you can include half the converted amount in gross income in 2011 and half in 2012. You’ll pay taxes on the converted amounts at the tax rates that prevail in those years.
How do you decide whether or not to defer the taxes?
The benefit from deferring the taxes is you have opportunity to earn a return on the tax money until the taxes are due. The deferral for 2010 conversions is interest-free, so you keep any income and gains earned from investing the money. Your return likely won’t be very high, because you should invest the money safely so the principal is available when the taxes are due. Investing in stocks or other risky investments provides an opportunity for a higher return, but you take the risk the investment will decline. You’ll have less money than you need to pay the taxes when they are due.
The potential disadvantage from deferral is tax rates might be higher in 2011 or 2012 or both. The higher taxes could offset all or most of your earnings on the tax money.
You need to estimate the amount you could earn from deferral. Then, decide whether your tax rate is likely to be higher or lower in 2011 and 2012 than in 2010. When you think it might be higher, estimate the additional taxes due from deferring the taxes. Compare that with the estimated return to determine if deferral is a winner or a loser for you. Deferring income and taxes usually is a clear winning strategy, but it might not be when tax rates rise.
January 2010. RW
