If you haven’t done so already, I would recommend that you read parts 1 and 2 of this blog post to understand the choice that you face regarding the year(s) for recognizing income if you do a Roth IRA conversion in 2010. This post will use the information presented in parts 1 and 2 to illustrate an example of the two options available.
As an example, let’s keep it simple and assume that your projected 2010, 2011, and 2012 pre-Roth IRA conversion taxable income is $175,000, your tentative 2010 Roth IRA conversion income is $150,000, and you prepare your tax returns using married filing joint status. Your projected 2010, 2011, and 2012 taxable income using the two potential income recognition scenarios would be as follows:
50% in 2011 and 50% in 2012
100% in 2010
The following is a comparison of the different amounts of projected 2010, 2011, and 2012 federal income tax liability under each of the two Roth IRA conversion income recognition scenarios (#1 = 50% in 2011 and 50% in 2012 and #2 = 100% in 2010) assuming that 2012 tax rates are the same as 2011:
While there is projected tax savings of $47,788 ($37,244 less $85,032) in 2010 from use of the Roth IRA conversion default method (defer 50% of income to 2011 and 50% to 2012), this is offset by additional projected tax liability of $24,974 ($65,876 – $40,902) in 2011 and 2012 so that total projected tax liability of $168,996 over the three years under Scenario #1 exceeds total projected tax liability of $166,836 under Scenario #2 by $2,160.
Unless you could achieve an after-tax rate of return of greater than 4.5% from investment of the 2010 tax savings of $47,788 to offset the additional total tax liability of $2,160 under Scenario #1, you would be better off by making the election to include 100% of your Roth IRA conversion income of $150,000 in 2010 assuming that you don’t have to borrow to pay the additional 2010 tax liability. Given the assumptions used in this example, it probably doesn’t make sense to defer recognition of Roth IRA conversion income to 2011 and 2012.
In which tax year(s) should you include your 2010 Roth IRA conversion income and how much of your traditional IRA should you convert to a Roth IRA in 2010? Professional guidance is highly recommended, if not necessary, in order for you to make the best decision given your financial goals and other facts unique to your situation.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.