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Special Tax Benefits for Roth IRA Conversions End in 2010!

If you are thinking about converting your IRA to a Roth IRA, don’t miss the opportunity to do it before the end of 2010. There is currently a provision in the tax code that allows IRA owners to convert some or all of their IRAs to a Roth IRA and get tax benefits that will not be available in 2011 and beyond.

There are two rules pertaining to Roth conversions that are waived for 2010, and it is important to know both since they will not be available after January 1, 2011. First, an IRA owner must normally have an adjusted gross income (AGI) of less than $100,000/year in order to qualify for a Roth conversion. In 2010 though, this rule is waived and anyone can convert regardless of their income.

The second rule applies only to conversions made in 2010. IRA owners can spread the income resulting from the conversion over the next two years, namely 2011 and 2012. When an IRA is converted to a Roth, the converted amount is added to the income of the IRA owner in the year of conversion and therefore taxed at that individual’s tax bracket for that year. However, for 2010 conversions only, all converted amounts can be split so that half of the income is added to the 2011 tax year and the other half to the 2012 tax year.

For example, if an IRA owner converts a $50,000 IRA to a Roth, they can add $25,000 to their income for 2011 and $25,000 to their income for 2012. This potentially allows an IRA owner to save a large amount of taxes on their conversions. Additionally, this provision allows the IRA owner to have a tax-free loan from the IRS for once.

To illustrate this, we discussed the fact that an IRA owner who converted $50,000 in 2010 can add $25,000 to the income for 2011 and another $25,000 for 2012. But when are the taxes due for the $25,000 which is added to the 2011 tax year? On April 15, 2012. That’s nearly 1-1/2 years away.

When are the taxes due for the $25,000 added to the 2012 tax year? On April 15, 2013. Therefore, even though you converted in 2010, you won’t have to make a final tax payment for nearly 2-1/2 years. Essentially, you have a tax-free loan from the IRS and this money can be invested until it has to be paid.

However, Roth IRA conversions may not be appropriate or make sense for every IRA owner. For example, if an IRA owner is charitably-minded, it may not make sense to convert because they can give their IRA to a charity and no taxes will be paid at all. As a matter of fact, the IRA owner would receive an income tax deduction, which would result in less taxes to pay! So before rushing out and converting, make sure you discuss your specific situation with a financial professional who understands the specifics of the conversion process.

For a more detailed discussion of Roth IRA conversions, see my 6/3/09 blog post titled “IRA-Roth IRA Conversion”.