Beginning January 1, 2010, the long-time $100,000 income restriction imposed on converting IRA’s to Roth IRA’s is eliminated.  Individuals, regardless of income levels, are then permitted to convert IRA’s to Roth IRA’s and may elect to either report the entire income triggered by the 2010 conversion in tax year 2010 or report the conversion income 1/2 in tax year 2011 and 1/2 in tax year 2012.  While the elimination of the income limitation appears to have no expiration, the election to spread the conversion tax liability over the 2011-2012 timeframe is only available for IRA to Roth IRA conversions undertaken in tax year 2010.  Please be aware that the income limitations for making Roth IRA contributions remain unchanged and the fact that a taxpayer converts an IRA to a Roth IRA does not mean the individual is permitted to make annual contributions to a Roth IRA.

Conversions to Roth IRA’s are allowed for any IRA’s including SEP-IRA’s, Simple IRA’s and Traditional IRA’s.  The amount converted which may include income deferred contributions, tax-deductible contributions and all earnings, is deemed taxable income and is taxed at the taxpayer’s federal and state ordinary income tax rates.  If the IRA account being converted contains non-deductible or after-tax contributions, those contribution amounts are not subject to taxation arising from the conversion.

Example:  On January 10, 2010 Margo decides to convert her traditional IRA account to a Roth IRA. The account’s value is $35,000 of which $10,000 are non-deductible/after-tax contributions and the remaining $25,000 are earnings and tax-deductible contributions.  When Margo prepares her 2010 tax return she may elect to either declare the entire $25,000 as income from the conversion or declare $12,500 in 2011 and the remaining $12,500 on her 2012 tax return.

One additional factor to consider when converting to a Roth IRA is the requirement for a five year holding period.  To satisfy the five year holding period, a Roth IRA distribution may not be made prior to the end of the five year period beginning with the tax year the individual made the conversion and ending on the last day of the individual’s fifth consecutive tax year after the holding period started. Generally a Roth IRA owner has only one five year period for all the Roth IRA’s he/she owns.  However unlike contributions, each conversion has its own five year holding period; thus a Roth IRA owner may acquire several five year holding periods due to conversion(s).  Distributions from conversion Roth IRA’s made prior to the five year holding period being met may be subject to the 10% early withdrawal penalty.

Example:  Using the same numbers from the example above, let’s assume Margo reaches 59-1/2 years of age during 2010.  In March, 2011 Margo decides not to include the conversion income on her 2010 tax return; rather, she elects to split the $25,000 conversion income between her 2011 and 2012 tax returns.  When Margo prepares her 2011 tax return in March, 2012 she declares $12,500 as income from the conversion and since Margo is in a 25% income tax bracket, she calculates that she will owe $3,125 ($12,500 * 25%) in additional taxes.  Margo decides that since she is older than 59-1/2 years, she can withdraw $3,000 from her Roth IRA to pay the additional tax without incurring any further tax liability.  In this case however Margo’s assumption is incorrect.  The conversion was made on January 10, 2010, thus the start of her Roth IRA holding period is January 1, 2010 and holding period end date is December 31, 2014.  Her withdrawal of $3,000 in March, 2012 is within the holding period and therefore a non-qualified distribution.  A portion of the $3,000 withdrawal will be subject to a 10% early withdrawal penalty on her 2011 tax return.

There are numerous reasons to convert an IRA to Roth IRA, but there are also many differences between IRA’s and Roth IRA’s.  Thus before you make the final decision to convert an IRA to a Roth IRA, you should contact our office to determine the tax implications as well as whether the conversion will meet your financial goals and objectives.