This year, all retirement savers> have had the opportunity to convert a traditional IRA to a Roth paying taxes on their nest egg today, in exchange for tax-free retirement income tomorrow. But without clarity on tomorrow s tax rates, it s been hard to know what to do, or when to do it. Now, if the tax proposal agreed upon this week by the White House and Republicans becomes law, savers will have three weeks of clarity in which to make their decision.
Until 2010, only people earning less than $100,000 a year were eligible to convert a traditional IRA to a Roth, a move that has the potential for tremendous tax savings, if rates rise in the future. This year, however, conversion was available to anyone, at any income level, with the option to pay the associated taxes in 2010, or to split the burden evenly between 2011 and 2012. Because the money in a traditional IRA has never been taxed as income, the taxes can be formidable on a large conversion, says IRA expert Ed Slott. To convert a $1 million account, for example, an investor at the 35% tax bracket would have to pony up $350,000 in taxes. (If the tax cuts had expired, that bill would have gone up to $395,000.) And without knowing the future tax rates, investors were left with a difficult choice: Pay a hefty tax bill at this year s low tax rates, or pay two, lower bills, but at potentially higher rates.
Now that current low tax brackets part of the Bush-era tax cuts are expected to remain the same through 2012, making the decision is easier. Here are the three choices:
Split payments between 2011 and 2012
Best for: People in the highest tax bracket and those who expect their incomes to remain the same over the next two years.
The tax rate on IRA conversions is based on your income tax bracket in each of the next two years. So if you expect your tax bracket to stay the same or drop, it pays to spread the payments on a conversion out. This is particularly beneficial for high-income households, which were most vulnerable to a tax increase, says Slott. If, on the other hand, you re angling for a raise or a new job with a higher salary that would kick you into a higher tax bracket, taking time to pay could cost more.
Pay up in 2010
Best for: Anyone expecting a raise or a bonus, or with a small IRA balance
Even with the tax package keeping overall tax rates relatively low, there are still brackets to consider. And if you re getting a raise or a bonus next year that could raise your bracket, better to take the tax hit now, says Julie Murphy Casserly, president of a wealth management firm based in Chicago. The other folks who might pay all at once? Those who can afford it, typically savers whose tax bill will be minor now because they have a low IRA balance and are in a low tax bracket, says Slott. Everybody s got to look at their own case, everybody s numbers are different, he adds. (See our worksheet below.)
Best for: People who can't afford the tax bill
Unless the rules change, all taxpayers will continue to be eligible for a Roth IRA conversion in the future, so there s no hurry, says Casserly. They can convert part of their traditional IRA this year and part in the future, she says. And investors should keep in mind that they can undo a conversion until October of the year following, says Slott.
So it might even be better to wait until January: Investors would have until October 2012 to undo it, if they find they can t pay the tax bill a full 11 months more than you d have if you converted now.
Roth IRA Worksheet
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Correction: The $100,000 income limit for Roth IRA conversions was permanently repealed in 2010. An earlier version of this article stated the income limit would be reinstated in 2011.>