April 18, 2011, is a red-letter day for some retirement-savers. It’s the tax return deadline for deciding whether or not to “split” a Roth IRA conversion that occurred in 2010. (The usual April 15th due date has been extended because of the Emancipation Day holiday in Washington, D.C., and the subsequent weekend.) The decision should reflect several key factors.
Background:Contributions to a traditionalIRA may be wholly or partially tax-deductible, depending on income limitsand whether you (or your spouse, if you are married) actively participate in an employer-sponsored retirement plan. When you receive distributions from a traditional IRA, the amount representing deductible contributions and earnings is taxed at ordinary income rates.
In contrast, Roth IRA contributions are never tax-deductible, but “qualified distributions” (e.g., distributions received after age 59½) from a Roth in existence for at least five years are completely tax-free. Furthermore, unlike a traditional IRA, you don’t have to take required minimum distributions (RMDs) after age 70½. If you convert a traditional IRA to a Roth, the taxable portion of the converted funds is taxed at ordinary income rates, just like a traditional IRA distribution.
Prior to 2010, you could not convert a traditional IRA to a Roth in a year in which your modified adjusted gross income (MAGI) exceeded $100,000. This restriction was lifted in 2010. Also, for a conversion occurring in the 2010 tax year—and 2010 only—you can choose to divide the taxable income from the conversion evenly over the following two years. In other words, you can split the tax bill on a 2010 conversion between your 2011 and 2012 tax returns.
Hypothetical example:Norma Jonesis usually in the 28% tax bracket, but a $100,000 conversion in 2010 would result in a portion of her income being taxed at the 33% rate. Norma may decide to have the taxable income split evenly between 2011 and 2012 if she expects all of the income to be taxed at the 28% rate for those two years. Thus, she will pay less tax overall while also deferring her payment.
Be careful, however, if you expect to be in a higher tax bracket after 2010 due to changes in your personal circumstances. For example, if you expect to generate a huge capital gain in 2011 from the sale of securities, you might opt to pay the entire tax due from the conversion on your 2010 return if your tax rate for 2010 will be lower than your projected 2011 rate. Other complications may arise due to potential alternative minimum tax (AMT) liability.
To help you determine the best approach for your situation, coordinate activities with the assistance of your professional advisers.