Your Money
By Sandra Block, USA TODAY
Ordinarily, taxpayers who convert a traditional individual retirement account to a Roth IRA must also pay up on Tax Day. In order to shelter future IRA earnings from taxes — the main reason most people convert to a Roth — you must first pay taxes on any pretax contributions and gains.
But this year, taxpayers who converted an IRA have the option of postponing the pain.
Roth IRAs were created in 1997 to encourage more Americans to save for retirement. The 1997 law also let investors convert traditional IRAs to a Roth as long as they pay taxes on any contributions or earnings that hadn’t already been taxed.
Congress also imposed income constraints on Roth Iras, making them off-limits to high-income taxpayers. The income limits on conversions were even more restrictive: Single or married taxpayers with modified adjusted gross income of more than $100,000 couldn’t convert.
The income limits on Roth contributions are still in place, but a law that took effect last year lifted the restriction on conversions. In addition, the law gave taxpayers who converted in 2010 the option of splitting the income tax from the conversion between 2011 and 2012.
For example, if you converted an IRA valued at $100,000 last year, and the entire IRA consisted of pretax contributions and earnings, you could opt to pay taxes on $50,000 of the income in 2011 and $50,000 in 2012.
For most taxpayers, this is an easy choice: Why pay taxes now when you can pay them later, at no extra cost? Congress agreed last year to extend the Bush tax cuts through 2012, so most taxpayers don’t have to worry about paying a higher tax rate on income recognized in 2011 and 2012, Charney says.
Deferral is the default option for paper filers and for taxpayers who use tax software. TurboTax, for example, advises users that paying the tax bill in 2011 and 2012 is the best option for most taxpayers.
Still, there are situations in which it could make sense to pay the entire tax bill in 2010. If you were unemployed in 2010 and are now back to work, for example, your 2011 tax rate could be higher. In that case, you may be better off paying the tax on the conversion when you file your 2010 tax return, he says.
By now, you should have received a 1099-R from your IRA provider, showing the amount you converted to a Roth. If you want to pay taxes on the entire amount in 2010, check the box on Line 19 of IRS Form 8606.
This is an all-or-nothing choice: You must either pay the entire bill in 2010, or split the income between 2011 and 2012. You can’t pay tax on a portion of the IRA income in 2010 and pay the rest in 2011 or 2012.
Other issues to consider if you converted an IRA to a Roth last year:
•The opportunity to defer income from a Roth conversion is a one-time deal. While Congress permanently eliminated income restrictions on Roth conversions, the option of deferring the tax bite was limited to 2010. If you decide to convert an IRA to a Roth this year, you’ll have to pay taxes on the income when you file your 2011 tax return. That’s in addition to any tax you’ll owe if you decide to defer income from your 2010 conversion.
•Spouses can treat their conversions separately. If you and your spouse converted IRAs to a Roth last year, you don’t have to make the same election, even if you file a joint return, says Frank St. Onge, a financial planner and enrolled agent in Brighton, Mich. For example, if one spouse converted an IRA valued at $50,000 last year and the other converted $100,000, the first spouse could pay taxes on their entire IRA this year, and the second could pay taxes on $50,000 in 2011 and $50,000 in 2012.
Needless to say, this is complicated stuff, and you may want to get professional help, particularly if you converted a large IRA last year.
Figuring out when to pay taxes on an IRA conversion, “is as much a financial-planning type of question as it is a tax-preparation question.”