At some point, taxpayers who have a traditional IRA may wish to convert it to a Roth. Roth IRAs are more flexible in that there are no required minimum distributions when the owner reaches age 70½. In addition, qualified distributions from a Roth IRA are not taxable.
Under current tax law, in the year you convert a traditional IRA to a Roth IRA, you must recognize the amount converted as income on your tax return, with the exception of any basis that may be in the traditional IRA. Depending on the amount, this can significantly impact your tax return. It can even bump you up into a higher tax bracket.
New legislation may make it worthwhile to hold off converting your IRA. For conversions made in 2010 only, the income from these conversions may be included in income over the two-year period beginning in 2011. For example, let’s say you convert a traditional IRA worth $40,000 to a Roth during 2010. You won’t need to report the conversion on your 2010 return, unless you elect to. Your 2011 and 2012 returns will each include $20,000 of income from the conversion.
Generally, if your income is more than $100,000, you currently are not eligible to make a conversion. However, beginning in 2010, this restriction will be eliminated and you’ll be able to make conversions regardless of your income or filing status.
Spreading Roth conversion income over two years will be advantageous for most taxpayers. Keep in mind, however, that the income tax owed is based on the value of your traditional IRA account at the time of conversion. If your IRA is invested in market securities (i.e. stocks and bonds), you should consider the value of those securities when timing a Roth conversion. You will pay less tax if you convert when values are depressed.
Consider the timing of a Roth conversion carefully and seek professional advice, especially when considering large conversions.