As years go, 2010 is on course to be a blockbuster for retirement-account owners. Starting in January, all Americans who own a traditional IRA — not just those who have modified adjusted gross income under $100,000 — will be able to convert their accounts to a Roth IRA. But don’t rush for the doors just yet. There’s plenty of slip between cup and lip waiting for those unaware of the conversion mistakes to avoid.
As some of you know, a Roth IRA is, in a way, the opposite of a traditional IRA. The Roth is funded with after-tax dollars; a traditional IRA with pre-tax dollars. Distributions from a Roth IRA are tax free while distributions from a traditional IRA are taxed at ordinary income tax rates. The original owner of a Roth IRA account is not required to take minimum distributions; the original owner of traditional IRA is required to start distributions after age 70 1/2.
Despite the obvious appeal of Roth IRAs, traditional IRA owners outnumber Roth owners by nearly two to one. In 2005, 37.5 million U.S. households owned traditional IRAs, while 18.6 million owned Roths, according to the Investment Company Institute.
There are a few reasons Roth IRAs aren’t as popular as traditional IRAs. For one, the traditional product has been around a lot longer. They were created in 1974; Roths came into existence in 1997. What’s more, the restrictions on who can contribute to a Roth are more onerous than those for traditional IRAs. And then, there are the rules that put a damper on who can convert their existing traditional IRA to a Roth. Before 2010, you could only convert your traditional IRA if you had modified adjusted gross income of less than $100,000. That changes on Jan. 1.
What’s more, the income tax due on conversions in 2010 can be spread over two years, with half paid in 2011 and half in 2012. It’s a sweet deal to be sure. So, let’s say your interest is piqued and you want to take advantage of all that a Roth IRA has to offer. Here are some mistakes should you avoid:
1. NEGLECTING TO DO THE CONVERSION
“Conversions are not for everyone, but the No. 1 mistake to avoid is to not do a conversion at all,” said Beverly DeVeny, an IRA technical consultant with Ed Slott and Co. LLC. “Why would you not want to pay taxes today at known — probably very low rates — to get tax-free income at a later date (probably at higher and maybe much higher rates)? You don’t have to convert the entire IRA all at once, but you should convert at least some of it.”
Others agree. The question is not whether but when and how, said Bruce Steiner, an attorney with Kleinberg, Kaplan, Wolff & Cohen. “For most people, the choices are (1) whether to convert all at once or over a number of years, and (2) whether to convert or start converting now, or later upon retirement,” Steiner said.
2. FAILING TO UNDERSTAND THE TAX CONSEQUENCES
While not doing a conversion might be a mistake, doing one without a thorough understanding of how the conversion will affect your taxes is an even bigger mistake, said Barry Picker, who recently served as the technical editor of “100+ Roth IRA Examples and Flowcharts,” by Robert Keebler.
“I’ve had people tell me that since they’re in the 15 percent bracket, they can convert their $1 million IRA and only pay 15 percent. It doesn’t work that way,” Picker said.
The additional income from the distribution of the traditional IRA would most likely bump you into a higher tax bracket.
3. CONVERTING WHEN YOUR TAX BRACKET IS LIKELY TO FALL
Truth be told, not all traditional IRA accounts holders should convert. Robert Keebler, a certified public accountant, partner at Baker Tilly Virchow Krause LLP, and author of “The Rebirth of Roth: A CPA’s Ultimate Guide for Client Care,” says it would be a mistake to convert if you are certain your tax bracket will fall in the next few years.
4. HAVING THE TAXES OWED WITHHELD FROM THE TRANSACTION
There are several reasons you should not have taxes withheld when requesting a conversion, said Denise Appleby, founder of RetirementDictionary.com and chief executive of Appleby Retirement Consulting. These include:
The amount withheld reduces the conversion amount. For instance if you request a conversion of $100,000 and ask to have 20 percent withheld for federal taxes, then $20,000 is paid to the IRS as an advance payment of income tax for the year. Technically, this amount is a distribution and not a conversion, and $80,000 is converted to your Roth IRA.
You may need to reverse the conversion for several reasons, including if the converted amount lost significant market value. This reversal is called a recharacterization. The result of a recharacterization is that the conversion is treated as if it never occurred, for tax purposes. But only the amount credited to the Roth can be recharacterized. For instance, if we use the example above, only $80,000 would be available. You would still owe income tax on the $20,000, because it would be treated as a distribution from your traditional IRA. An exception applies if it has been at least 60 days since the conversion was completed. Under this exception, the amount withheld for income tax can be rolled over to the traditional IRA. Of course, this exception is useful to you only if you can come up with the funds out of pocket.
The amount withheld for taxes is subject to the 10 percent early distribution penalty unless the IRA owner is at least age 59 1/2 when the conversion occurs, or qualifies for an exception to the penalty.
5. CONVERTING TO JUST ONE ROTH IRA
Another mistake, according to Picker, is converting your traditional IRA into an existing Roth IRA account. “Every conversion goes into a brand new Roth account,” he said. “You can consolidate later, after the recharacterization deadline.”
Indeed, many experts suggest that you convert your traditional IRA into as many Roth IRA accounts as possible, each with investments of a similar type. With Roth IRA conversions, Uncle Sam lets you switch back to a traditional IRA before a certain date should the value of the account fall below the original conversion amount.
6. FORGETTING TO CONSIDER A RECHARACTERIZATION
Not converting is one possible mistake. Not watching the value of your Roth IRA accounts after you’ve converted is a big mistake too, Keebler said. Indeed, there are some tax-saving opportunities that come when the value of your converted Roth IRA accounts falls significantly and you undo the conversion.
According to Appleby, when pre-tax amounts are converted to a Roth IRA, income tax is owed on that amount. This rule applies even if the market value falls below the taxable amount of the conversion. For instance, if you convert $100,000 in pre-tax dollars and the market value falls to $50,000, income tax is owed on the $100,000.
“The good news is that taxable conversion transaction can be reversed (recharacterized), if it is done by your tax filing deadline, including applicable extensions. The recharacterization can be done, even if your tax return has already been filed, as an amended tax return can be filed to reflect the removal of the conversion from the individual’s taxable income,” she said.
“Many fail to take advantage of this opportunity for various reasons including lack of awareness and missing the deadline, and as a result, pay a higher tax bill than they need to,” she said. “To prevent this from occurring, individuals should check the value of their conversions shortly before the deadline for recharacterizing and — if the market value has fallen significantly — instruct their financial institutions to recharacterize the amount.”
Appleby said the deadline for completing the recharacterization is the tax filing due date, plus an additional six months if the individual files for an extension by his tax due date. You can then re-convert the amount when eligible to do so.
In the example above, Appleby said that if the market value remains at $50,000, recharacterizing and then reconverting would result in the account owner owing a tax bill on $50,000 instead of $100,000.
(c) 2010, MarketWatch.com Inc. Source: McClatchy-Tribune Information Services.