People who did Roth conversions in 2010 now face the issue of how to manage the resulting income. With the Bush tax cuts having been extended through 2012, many will want to take advantage of a special rule, which applies only to 2010 conversions, allowing half the income to be taxed on their 2011 return and half on their 2012 return. This isn’t the optimal approach for all people, however. If you did a Roth conversion in 2010 and don’t want the income to be taxed in this manner, there are four ways to get a different result.
The first way to get a different result is simply to elect out of the deferral rule. There’s a checkbox on line 19 of Form 8606 (PDF) where you can choose instead to have the income taxed on your 2010 income tax return. This is an all-or-nothing choice. You can’t simply choose to have a third of the income taxed on your 2010 return, with the remainder split between your 2011 and 2012 returns.
The choice is all-or-nothing even if you did separate Roth conversions involving separate IRAs. You get to make only one choice, affecting all income from all your 2010 Roth conversions.
If you’re in a situation where you need to have some of your conversion income taxed in 2010 and the rest taxed in later years, one way to do that is to use a recharacterization to undo part of the conversion. You would leave enough of the conversion in place to produce the amount of income you want to have taxed in 2010. Subsequent conversions in later years would move conversion money into those years.
Example: You converted a $60,000 IRA in 2010, but it now appears best that you have $20,000 of income taxed in 2010 with the remainder split between 2011 and 2012. One possible strategy is to undo two-thirds of the conversion and elect out of the deferral rule as explained above, so $20,000 would be taxed on your 2010 return. Then convert half of the remainder in 2011 (after the 30-day waiting period) and the rest in 2012.
The main problem with this approach is that the total amount of income you report from your conversion may go up. Perhaps your IRA was worth $60,000 at the time of the original conversion, but it’s now worth $66,000. When you undo two-thirds of the conversion, you have to move $44,000 back to the traditional IRA, not just $40,000 (the amount of income you want to eliminate from the conversion). You might then have to report $22,000 of income to convert half the remainder in 2011, and perhaps $25,000 or more to convert the rest in 2012 if your investments continue to perform well.
This is a strategy that could work well, especially if your retirement account is conservatively invested, but it can also backfire if your investments have the potential for rapid growth.
Distributions to accelerate income
The third possible strategy is one I would rarely recommend, but it’s out there and may be desirable in some unusual circumstances. If you’re using the deferral approach (the one where half the income is taxed on your 2011 return and half on your 2012 return), you can accelerate income into an earlier year by taking distributions from the Roth after the conversion. A reader responded to an earlier article by asking how this would be possible. After all, the income is now in a Roth: how would a distribution of this money produce taxable income? Let’s understand how this rule works.
The deferral rule allows you to postpone paying tax on the Roth conversion money, but only if you leave it in the Roth. Taking money out before 2012 won’t change the amount of taxable income you have from the conversion, but it will cause you to pay tax on that income in an earlier year.
- Distributions of the conversion money in 2010 will move some or all of the 2012 income into 2010. If the 2010 distributions exceed the amount that would have been taxed in 2012, they also move income from 2011 into 2010.
- Distributions of the conversion money in 2011 will move some or all of the 2012 income into 2011.
Example: You converted a $60,000 IRA in 2010 and chose to use the deferral rule, which would normally mean you’d pay tax on $30,000 in 2011 and another $30,000 in 2012. You pulled $10,000 out of the IRA in 2010 and took no distributions in 2011. The result would be $10,000 taxed in 2010, $30,000 taxed in 2011, and $20,000 taxed in 2012.
It’s too late to use this strategy to move income into 2010, so unless you already took a distribution in that year the only remaining opportunity is to shift some of the income from 2012 to 2011 by taking a distribution this year.
Example: You deferred the income from a $60,000 Roth conversion and now it appears advantageous to have $40,000 taxed in 2011, rather than splitting the income equally between 2011 and 2012. You can accomplish this by taking a $10,000 distribution of the conversion money in 2011.
This strategy has some severe drawbacks, however. For one thing, you can’t withdraw 2010 conversion money until you’ve withdrawn all regular contributions you’ve made to Roth IRAs, and all money converted in years prior to 2010. More importantly, taking money out of a Roth runs counter to your reasons for building the retirement account in the first place, maximizing the tax benefits of your savings. Unless you achieve some hefty tax savings from this strategy, or your situation is such that it might make sense for you to withdraw money from your Roth at this time, the long-term effect may end up being negative.
Disagree with your spouse
The final strategy is available only if you and your spouse both did Roth conversions in 2010. Let’s be clear about what that means.
In a comment on an earlier article, one of our readers said, “I’m married, we jointly own everything, but there is only one normal IRA and one Roth IRA account (in my name for account management purposes). Can we treat half the distribution aas income for one spouse and half as income for the other, even if coming out of a single account?” No! You do not jointly own everything. Perhaps you jointly own everything else, but there is no such thing as joint ownership of an IRA. The “I” stands for “individual.” You are sole owner of these IRAs, and if you spouse wants to have an ownership interest in a retirement account, your spouse will have to set up a separate one.
This strategy is available only for married couples who both did Roth conversions (to their own separate Roth IRAs) in 2010. Even when you file jointly, Form 8606 — the one used to report Roth conversions — is an individual form. Your return will include two of these forms, and one of you can use the deferral rule while the other does not.
Example: You and your spouse each converted a $30,000 IRA. If one of you uses the deferral rule, and the other elects out of this rule as explained earlier, you’ll report $30,000 of income on your joint 2010 return and $15,000 per year on your joint returns for 2011 and 2012.
It is, of course, too late now to arrange these multiple conversions — but not too late, for couples where both did Roth conversions in 2010, to consider whether it might work best for one of them to elect out of the deferral rule and, if so, which one.
If you still have money in a traditional account that’s eligible for conversion to a Roth, now is a good time to think about taking that action. Converting early in the year is advantageous in several ways. You have the greatest amount of time between the date of the conversion and the due date of your tax return; you make an earlier switch from generating tax-deferred income to generating tax-free income, and you get a longer lookback if poor investment performance or other unexpected events lead you to want to undo the conversion.