2010 Roth IRA Conversion, Important Things to Know

By Andy Tenton, on January 11, 2010

Prior to 2010, individuals were permitted to convert a traditional IRA to a Roth IRA under the tax law for Roth IRA conversion.  There were only two stipulations that governs the conversion: (1) you have to pay taxes on the converted money and (2) you must be within the income limit which determined your eligibility to convert. However, 2010 brings a big change that temporarily eliminates the income limit and everyone can convert their traditional IRAs to a Roth IRA.

Rules for Converting an IRA to a Roth

When contributing to your traditional IRA, you can add money into the account on a pre-tax (tax deductible) and after-tax basis.  Your investment is allowed to grow on a tax-deferred basis until withdrawn in retirement. If you wanted to convert a traditional IRA to a Roth IRA, you had to pay federal income taxes on any pre-tax contributions as well as any growth in the investment’s value.  Once converted to a Roth, all of the investment could from now on be withdrawn on a tax-free basis in retirement.

Income Limits on Conversions

Unfortunately, the tax law for Roth IRA conversion also contained a provision limiting who could make a conversion.  Upper income taxpayers, specifically those with adjusted gross incomes of more than $100,000 (whether single or married) were not eligible to make the conversion.

Phase Out Limits for Roth IRA Contributions

Moreover, if you earned more than the IRA phase out limits (for 2010, it’s $120,000 for single and $177,000 for married joint filers) then you also weren’t eligible to contribute to a Roth IRA at all.

These two tax laws effectively excluded upper income taxpayers from enjoying the benefits of a Roth IRA.  They could not convert their traditional IRA to a Roth, and they could not fund one either.

What’s Special about Roth IRA Conversions in 2010

In May of 2006, President Bush signed a $70 billion tax cut provision that changed the eligibility rules for Roth IRA conversions.  Starting in 2010, taxpayers that were previously excluded will be allowed to convert their traditional IRAs to Roth IRAs. This change starts in 2010 and continues indefinitely.

Special tax provision for 2010 conversions

Additionally, there is a special provision for conversions made in 2010 where the income taxes due on the 2010 conversion can be deferred and spread over two years in 2011 and 2012 tax years.  So half of the 2010 conversion amount may be included as taxable income in 2011 and another half in 2012. This significantly help reduce your annual tax liability.

Conversions in subsequent years are included in income during the tax year in which the conversion is completed.

How to Take Advantage of the 2010 Roth IRA Conversion Rule

Bypassing the Roth IRA Phase Out Limits

If you are not eligible to contribute to a Roth IRA, you can now get around the phase out limit by contributing to a traditional IRA on a after-tax basis — and this applies to your 2009 IRA contribution as well! After you’ve made your traditional IRA contribution, you could convert the amount to Roth without any tax liability.

Lower your Future Tax Burden

If you believe that you will be in a higher tax bracket when you start withdrawing from your IRA than the tax bracket you would be in if you convert your traditional IRA to Roth, then conversion might make sense. By converting now, you’re paying taxes today for the privilege of not having to pay any taxes upon withdrawal.

A good strategy to follow is to straddle the 15% tax bracket. Basically, if your income put you within the 15% tax bracket, then convert enough money to put you right up against the upper limit of 15% tax bracket. However, if you are above the 15% tax bracket, the conversion may not make sense for you.

Should You Convert?

While the idea of having something grow completely tax-free from now on, it is important to understand that the conversion, or even contribution to a Roth IRA, is not for everyone. Before converting you might want to read this article to help you choose between a Roth IRA and a Traditional IRA.  If you’re still not sure about what is the best choice for you, it might be a good idea to consult with a tax professional before making your move.

Recommended articles:

• Traditional and Roth IRA Contribution Limits for 2010
• 2010 Roth IRA Conversion Rules, What Is The Big Deal?
• IRA Contribution Limits And 401k Contribution Limits, 2009
• 5 Tax Deductions To Take This Year
• Fixed Annuities Pros and Cons
• Important Considerations For Those Who Want To Retire Early
• How to File a Federal Tax Extension

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Andy Tenton is a freelance writer with strong interest in personal finance. He recently started his own blog, Money Destiny.

All posts by Andy Tenton

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