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Estate Planning

: North Carolina Estate Planning Blog

Decision Time is Here if You Did a Roth IRA COnversion in 2010

By Greg Herman-Giddens

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The rule that made higher-income folks ineligible for Roth IRA conversions expired at the end of 2009. That made 2010 a big year for conversions, because even billionaires could make the transactions. If you are among the many who took advantage last year, that's great, but there's more to the story. You still have some major decisions to make in 2011.

Here's what you need to know.

When to Report the Taxable Income from a 2010 Conversion?

You have the option of deferring the taxable income triggered by a 2010 Roth conversion and then spreading it evenly over 2011 and 2012 (50 percent in each year). Other things being equal, the deferral option is obviously a good idea.

You also have the alternative option of reporting 100 percent of the conversion income on your 2010 return instead of deferring it to 2011 and 2012.

Now that the Bush-era tax cuts have been extended through 2012, the deferral option is the best choice for most taxpayers. However, there are exceptions.

If you believe you'll pay a significantly lower tax rate on the conversion income by reporting it all in 2010, you should probably do that. For instance, say your 2010 income was depressed, but 2011 and 2012 are looking good. In this scenario, reporting all the conversion income on your 2010 return and paying a lower conversion tax bill might make it worthwhile to pay the bill sooner rather than later.

You make the choice to report 100 percent of the conversion income in 2010 by including a certain form with your 2010 Form 1040. This is how you also make the deferral choice -- by filing an IRS form with your tax return. Your tax adviser will take care of the details.

Deciding Whether to Reverse an Ill-Fated 2010 Conversion

You have until the October 17, 2011 extended deadline for filing your 2010 Form 1040 to reverse an ill-fated 2010 Roth conversion by "recharacterizing" the converted account back to traditional IRA status. Note that the October 17, 2011 deadline applies whether you actually extend your 2010 Form 1040 or not.

Why would you want to reverse a conversion? Consider the following example.

Example: In 2010, you converted three traditional IRAs into three Roth accounts. We'll call them Roth IRA-1, Roth IRA-2, and Roth IRA-3.

In 2011, the value of Roth IRA-3 takes a big dive due to horrible performance by the investments chosen for that account. If you take no action, you'll owe income tax on Roth IRA-3 value that no longer exists. This is not good!

But you have until October 17, 2011 to reverse the Roth IRA-3 conversion by recharacterizing that account back to traditional IRA status. After the reversal, it's as if the Roth IRA-3 conversion never happened, so the related conversion tax bill simply goes away.

Deciding Whether to Extend Your 2010 Return

If you did a Roth conversion last year, there may be two good reasons to consider extending your 2010 Form 1040 to October 17, 2011.

Reason No. 1: Extending gives you more time to decide if you should choose the deferral option (which would result in splitting the taxable income from your 2010 conversion evenly between 2011 and 2012) or choose the alternative option of reporting 100 percent of the conversion income on your 2010 return. As we explained earlier, the deferral option is probably the right choice in most cases, but it depends on how your 2010 tax rate compares to your expected rates for 2011 and 2012. By October, you'll have a better handle on those years than you do right now. So extending is a no-brainer. Do it by filing Form 4868 on or before April 18, 2011.
Reason No. 2: Filing an extension makes it simpler to handle the reversal of a 2010 conversion, if a reversal becomes advisable. If you extend your 2010 Form 1040, you report a reversal by simply showing no income from the now-reversed conversion on your return. That would be easy. But if you decide on a reversal after shipping off your return, you'll have to file an amended return (using Form 1040X) to delete the conversion income. That is still possible but not as easy.

The Bottom Line

The book is still open on your 2010 Roth conversion deal, because you must make important decisions in 2011. First and foremost, you may want to extend your 2010 return to give yourself extra time to make those decisions. Even if you've never extended before, doing it this time around might be a good idea. Consult with your tax adviser if you have questions about your situation.

Source: TrustCounsel's March 22, 2011 eNewsletter (BizActions).

Full post as published by North Carolina Estate Planning Blog on March 22, 2011 (boomark / email).