Worried About Higher IRA Taxes? Convert!

As you probably know, the lower income-tax rates enacted during George W. Bush’s presidency are set to expire at the end of the year, in the absence of Congressional action. Democrats, especially those facing re-election, considered the topic such a hot potato that they tabled all discussion until after Nov. 2.

So here’s the question: With a little more than two months remaining, not to mention time off for major holidays, do you honestly believe Congress has the will or the ability to resolve this issue before the clock strikes midnight on Dec. 31?

Personally, I predict we will remain in tax limbo well into next year. So I’ve hedged my bet: I converted my traditional IRAs this year.  And, I intend to declare the entire taxable portion as 2010 income even though I could postpone doing so and instead declare 50% as 2011 income and 50% as 2012 income.

The tax that will apply to my Roth conversion will be whatever rates are in effect in the year I declare the amount as income.  If income tax rates go up next year, I’ll end up with a bigger tax bill than I would this year.  As I look at it, at least I know what my maximum income tax rate is going to be in 2010.

But I’ve got plenty of time to wait and see what happens. Roth conversions come with something the Internal Revenue Service rarely offers: the right to change your mind.  In IRS-speak it’s called a “re-characterization.”  Translation: You can cancel a Roth conversion, move the assets back into a traditional IRA and pretend they never left.  No harm, no foul.

Best of all, you have until the last day you are allowed to file your federal income tax return with extensions: Oct. 15 of the following year.This gives you more than 10 months to see what, if anything, Congress does with income tax rates.

If the current rates are extended, I have until Oct. 15, 2011 to decide whether to stick with my game plan and declare 100% of my conversion as 2010 income or divide the amount- and the tax due- between 2011 and 2012. (I don’t advocate waiting until the 11th hour to re-characterize a Roth conversion and file your income tax return.  If, for some reason you hit a snag, you’ve got no time to work things out!)

By the way, because tax on a conversion is based on what the assets were worth on the day you converted, this strategy also allows you to hedge the financial markets. For instance, say you converted last May and a year later the assets in your Roth IRA declined by 20%.  Instead of paying tax based on the value of your assets in May 2010, you might decide to cancel your conversion.  You have until Oct. 15, 2011 to consider re-characterizing.

You can then re-convert the same assets as long as you meet two conditions:

1) the re-conversion must take place in a different calendar year than when the original conversion occurred;

2) at least 30 days after you re-characterized.  Thus, a 2010 conversion that is re-characterized on Sept. 6, 2011 could be re-converted as early as Oct 6, 2011.

Ms. Buckner is a Retirement and Financial Planning Specialist at Franklin Templeton Investments. The views expressed in this article are only those of Ms. Buckner or the individual commentator identified therein, and are not necessarily the views of Franklin Templeton Investments, which has not reviewed, and is not responsible for, the content. 

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