The Tax Deal: Rethink Roth Conversions?

December 9, 2010

It’s going to be quite a scramble to figure out what planning moves make sense in light of a suddenly changing tax landscape. One item sure to draw the attention of many is Roth conversions. Will they become more attractive? Or possibly, for some people, less attractive?

The tax deal between President Obama and Republican leaders in Congress is still taking shape — and while opposition from the left appears to be fading, its passage is not yet assured. The provisions that are most important in connection with Roth conversion planning are unlikely to change, however: income tax rates will remain unchanged (except for inflation adjustments, presumably) for 2011 and 2012. That’s a major difference from where we were earlier this year, with many people expecting 2011 to bring higher tax rates to high-income taxpayers. The change makes Roth conversions more attractive for some people and less attractive for others.

Special year

The year 2010 is special for Roth conversions in two ways. It’s the first year in which high-income taxpayers (in this case meaning those with modified adjusted gross income above $100,000) are permitted to convert traditional IRAs to Roth IRAs. It’s also the only year for which conversion income can be deferred: you’re allowed to report income from 2010 conversions on your 2010 income tax return, but you can choose instead to report half the income on your 2011 return and half on your 2012 return.

Backing off

Some folks aren’t sold on the idea of a Roth conversion, but were prepared to pull the trigger because it looked like 2010 might be the last year before higher tax rates took effect. If your only reason for doing a Roth conversion was to beat the rate increase, it now appears you can delay that action at least two more years — and a lot can happen in that time, perhaps including a move toward major reform of the tax system. Delaying your move will eliminate the benefit of deferring income on your conversion, which is an option only for 2010 conversions. Yet some people will be willing to abandon that benefit in exchange for the opportunity to wait and see whether a Roth conversion is in their long-term interest.

Waiting until next year provides one other potential advantage: you get a longer lookback period for undoing your conversion. Anyone converting in December 2010 has only until October 15, 2011 to back out if the conversion goes sour, as in the case where investments lose much of their value after the conversion. Converting in January 2011 gives you until October 2012 to decide whether to undo the conversion.

Ramping up

There are others for whom the tax deal gives the idea of a Roth conversion at least a slight added boost. Back when it looked as if tax rates would be going up in 2011, the opportunity to defer conversion income into 2011 and 2012 may not have looked like much of a benefit. Yet if the tax deal goes through we can be a lot more confident that those who convert in 2010 won’t be hit with higher rates if they take advantage of the deferral feature.

Clearing the air

Also affected by the deal are people who already converted and were waiting for more information before choosing whether to defer the conversion income to 2011 or 2012. Strictly speaking, you aren’t locked into this decision until October 15, 2011. However, as Janet Novack, who writes the Taxing Matters blog on, reminded me, people who pay state income tax on their conversion income have to make at least a tentative decision by the end of 2010. If you’re reporting the conversion income in 2010, it’s probably in your interest to pay the state income tax, or a big chunk of it at least, as an estimated tax payment before the end of the year. Otherwise the itemized deduction for that payment won’t fall in the same year you have this boost in taxable income. The result could be that the alternative minimum tax (AMT) deprives you of much of the benefit you would otherwise get from that deduction.

With the tax rate situation becoming clear before the end of the year — instead of being held over to next year, as might well have happened if President Obama had chosen to stonewall this issue — people in this situation can choose their method of reporting the conversion income ahead of time and make their state income tax payments accordingly.