Deadline Nears for Spreading Tax on Roth Conversion
If you want to take advantage of a one-time option to spread your tax bill over two years, you must convert to a Roth IRA by year-end.
This is the first year that anyone, regardless of income, can convert a traditional IRA to a Roth. Although you will have plenty of chances in the future to swap your tax-deferred retirement account for a Roth -- and pay taxes on the amount you convert -- 2010 is the only year that you have the option of spreading the tax on that conversion over two years. The window closes on December 31.
So if the prospect of creating tax-free income in retirement appeals to you, you might want to take the plunge and convert to a Roth by year-end. If you change your mind, you can undo the conversion later, and it won’t cost you a dime.
In most cases, you'll owe taxes on the entire balance when you convert a traditional IRA to a Roth IRA. But after that, all future earnings and withdrawals are tax-free, subject to certain rules.
If you’ve made both deductible and nondeductible contributions to your traditional IRAs, your tax bill will be based on the ratio of nondeductible contributions to the total balance in all of your traditional IRAs. If your total balance is $100,000, for example, of which $20,000 represents nondeductible contributions, then 20% of any conversion would be tax-free.
If you convert to a Roth in 2010, you can spread the tax bill over two years. You report the first half of the conversion on your 2011 tax return (which you file by April 15, 2012) and the balance on your 2012 return (due April 15, 2013). The delay should give you plenty of time to stockpile cash to pay the tax bill. However, if you're converting a large IRA balance, you may want to start making quarterly estimated tax payments for 2011 to avoid an underpayment penalty.
Or, if you are concerned about future tax hikes, you could pay all the tax on your 2010 conversion at your current tax rate when you file your 2010 tax return next spring. That could be a smart move for upper-income Americans who are concerned that tax rates will rise if the Bush tax cuts are allowed to expire at the end of this year. In that case, you might face a higher rate that could more than undo the benefit you’d receive by putting off the tax bill.
How much will it cost you to convert an IRA? That depends on several factors: how much you convert, how much other taxable income you have and your top marginal tax rate. Kiplinger has developed a calculator to estimate the cost of converting part or all of your traditional IRA to a Roth. Answer three questions and we’ll estimate your tax bill under several different possibilities:
•If you pay tax on the conversion with your 2010 return.•If you split the bill over 2011 and 2012 under three different scenarios:
1) The Bush tax cuts expire.2) The Bush tax cuts are extended for all taxpayers.3) The Bush tax cuts are extended for all taxpayers except those in the top two tax brackets.
Our Roth IRA Conversion Tax Calculator will give you a rough estimate of the cost of converting to a Roth based on certain assumptions, including that your income (not counting the conversion) remains relatively stable in 2010, 2011 and 2012. The calculator does not take into account any possible impact of the alternative minimum tax.
And if you convert to a Roth this year and get cold feet, you'll get a chance to change your mind. You'll have until October 17, 2011, to "recharacterize" your 2010 conversion -- switch the account back to a traditional IRA without owing taxes. Or, if you have already paid your tax bill by then, you can apply for a refund.