Roth IRA Conversions – Don’t Let the Tax Tail Wag the Dog – Part 1 of 6

Roth IRA Conversions – Don’t Let the Tax Tail Wag the Dog – Part 1 of 6

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I’m always amazed at how many people are motivated solely by tax incentives when it comes to investment decisions, paying little attention to, and in many cases, completely ignoring the potential long-term economic benefits that should be the driving force behind implementation of any investment strategy. With 2010 behind us, I can safely say that the Roth IRA conversion decision definitely falls in the “tax tail wag the dog” category.

Although the jury is still out on how many 2010 Roth IRA conversions will stick due to the ability to recharacterize, or undo, a Roth IRA conversion by the tax return due date (April 18, 2011), plus extension (October 17, 2011), of the conversion year, 2010 should turn out to be a banner year for Roth IRA conversions. The last time that Roth IRA conversions received so much attention was in their debut year in 1998 when the IRS allowed you to spread the tax from a conversion over four years.

So, even though the ability to do a Roth IRA conversion has been around since 1998, what was different about 2010 that drove more people than usual to consider, and actually transfer, a portion, or all in many cases, of their traditional IRA accounts into Roth IRA accounts? Two things: (1) Before 2010, only taxpayers with modified adjusted gross income (“MAGI”) of less than $100,000 were able to convert a traditional IRA to a Roth IRA. With the removal of this threshold in 2010, everyone with a traditional IRA account became eligible to do a Roth IRA conversion. (2) The “tax tail wave the dog” provision that enabled 2010 converters to avoid inclusion of the income from their conversion on their 2010 income tax returns and instead defer 50% of it to 2011 and the other 50% to 2012. As a matter of fact, this is the default. In order to report the income from a 2010 conversion on your 2010 tax return, you’re required to make an election to do so by checking a box on Line 19 of Part II of Form 8606 – Nondeductible IRAs when you file your 2010 income tax return.

While the $100,000 modified adjusted gross income change opened the door to more converters, this change, in and of itself, wasn’t, and shouldn’t continue to be, a reason for higher income individuals to do a conversion. Even though I labeled factor #2 the “tax tail wag the dog” provision, when you examine it closer, it was actually a potential tax trap for many individuals at the time it came into being. Prior to the enactment of the 2010 Tax Relief Act on December 17th, marginal income tax rates were scheduled to increase from 10, 15, 25, 28, 33 and 35 percent to 15, 28, 31, 36, and 39.6 percent. Consequently, up until the last two weeks of 2010, even though 2010 conversion income could be deferred to 2011 and 2012, it appeared that it would be subject to higher tax rates in many cases unless an election was made to report the income in 2010.

It’s ironic that many people who did conversions before the 2010 Tax Relief Act was enacted were motivated solely by the ability to defer the inclusion of their conversion income from 2010 to 2011 and 2012. When faced with the prospect of higher tax rates beginning in 2011, many of these individuals should have instead been prompted to do their conversions in 2010 due to the fact that they could take advantage of lower tax rates by electing to report the income from their conversions on their 2010 income tax return.

So what are the long-term economic benefits of a Roth IRA conversion that should have overridden any potential tax incentives in 2010 and should continue to do so in 2011 and in future years? You’ll have to wait until next week when you read Part 2 of this post to find out.

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