Last year, many advisors worked with clients to implement Roth conversions. But now that we're in the 2011 tax season, the questions about the tax effects of conversions will become more frequent. Advisors should be ready for a slew of new tax-related questions about 2010 and 2011 Roth IRA conversions. Here are some of the most frequent questions I receive from financial advisors.
* Has a conversion taken place in 2010 or 2011? Check and see when the funds were distributed from the IRA or company plan. For example, if the funds were withdrawn on Dec. 31, 2010, and not deposited into a Roth IRA until Feb. 15, 2011 (must be within 60 days of the withdrawal), it's still qualifies as a 2010 Roth conversion.
The five-year Roth conversion clock will begin on Jan. 1, 2010, even though the funds did not get into the Roth IRA until 2011. If this is your client's first Roth IRA, the five-year clock for qualified distributions will also start on Jan. 1, 2010. In this case, there really is only a four-year clock, since one year will have already passed by the time the funds are converted to a Roth IRA.
Also, since this is a 2010 conversion, your client has the opportunity to split the conversion income equally between 2011 and 2012, even though the funds were actually deposited in the Roth IRA in early 2011. On the other hand, if the funds are not distributed until Jan. 1, 2011, this becomes a 2011 conversion. You do not have until April 15, 2011, to do a 2010 conversion.
* How is the tax paid under the two-year Roth conversion payout provision? Financial advisors are often confused about this question. It's not the tax that is spread over two years; it's the Roth conversion income. Therefore, the ultimate tax burden will depend on a number of items, including your client's income, deductions, credits and exemptions, as well as the income tax rates in the years that your client includes the conversion income.
For example, assume Jim converts $100,000 to a Roth IRA in 2010. He does not have to include any of the $100,000 Roth conversion income in 2010. Instead, he can spread the conversion income equally over 2011 and 2012. Jim will report $50,000 of Roth conversion income in 2011 and the other $50,000 in 2012. If he uses this two-year deal, the tax will be determined in part by the income tax rates in effect in 2011 and 2012.
Jim also has the opportunity to elect out of the two-year deal and include the entire $100,000 Roth conversion income in 2010. This might be to his benefit if the tax rates are lower.
If the tax rates for 2010 are extended to 2011 and 2012 (meaning the tax rates will be the same for 2010, 2011 and 2012) then (all other factors being equal) clients should take the two-year deal since there is no increased tax cost and they get to hold on to their money longer (and earn more interest) before they have to pay the tax bill. In this case, the only reason to opt out of the two-year deal and include all the conversion income in 2010 is if 2010 was a much lower income year or the client had high deductions or business losses to absorb conversion income and lower the tax.
Note that the two-year payout deal is only for 2010 conversions. For conversions in 2011 or later years, all the conversion income will be included in the year of conversion.
* Can clients include some of the 2010 Roth conversion income in 2010, some in 2011 and the rest in 2012? No. Either the Roth conversion income is reported under the two-year deal, half in 2011 and half in 2012, or the entire amount is reported in 2010.
But there may be a way to simulate reporting Roth conversion income over the three years if your client is a married couple and they each have IRAs or plan funds they converted in 2010. Since IRAs are individual accounts, each spouse can elect a different method. One spouse can convert an amount and elect to report all of the conversion income in 2010 and the other spouse can use the two-year option. Since all of the Roth conversion income will be reported on the same tax return (if they file married jointly), they can simulate a three-year payout this way.
* Can clients who choose to report all the 2010 Roth conversion income in 2010 later change their mind? Can they file an amended tax return to spread the Roth conversion income over 2011 and 2012, if that proves to be a better deal for them? No. The choice to report all of the 2010 Roth conversion income in 2010 is irrevocable, but if the taxpayer has filed an extension until Oct. 17, 2011, the decision can be made then. In that case, your client still should have the right amount of tax paid in for 2010 by April 15, 2011, in case he or she chooses to report all of the conversion income in 2010.
The extension is only an extension of time to file the tax return, not to pay the tax. If the right amount of tax is not paid in by April 15, 2011, your client could be subject to estimated tax penalties. On the other hand, if the tax is paid in by April 15, 2011, and the client decides not to report any 2010 Roth conversion income in 2010 but instead to use the two-year option, then any tax overpayment for 2010 can be either refunded or credited to the 2011 return.
* Are there any remaining restrictions on who can convert to a Roth IRA in 2011? No. The $100,000 modified adjusted gross income (MAGI) eligibility limit was repealed after 2009 for all future years. The restriction preventing married persons who file separate returns from converting was also repealed. Unlike the two-year deal on Roth conversions, which was only available for 2010 Roth conversions, the repeal of the Roth conversion income limit is permanent.
* Is there still an income limit on who can contribute to a Roth IRA for 2011? It seems odd; there's no income limit on Roth conversions, so your clients can move seemingly unlimited funds to a Roth IRA, but there's still an income limit on who can contribute much smaller amounts to a Roth IRA.
In order to contribute the maximum amount to a Roth IRA for 2011, which is $5,000 (or $6,000 if age 50 or older in 2011), income cannot exceed $179,000 (married filing joint) and $122,000 (single or head of household). These limitations can be easily bypassed, however. Anyone with at least $5,000/$6,000 of earned income (wages or self-employment income) can contribute the $5,000/$6,000 to a nondeductible traditional IRA and then convert those funds to a Roth IRA, since there is no income limit for Roth conversions. A word of warning though, the pro-rata rule will apply if your client has other IRA funds.
* Can IRA beneficiaries convert their inherited IRA funds to an inherited Roth IRA? No. But beneficiaries who inherit funds from a company plan (a 401(k) plan, for example) can convert those inherited funds to an inherited Roth IRA. If they converted in 2010, they would have the same payout options as anyone else who converted in 2010 (all in 2010 or the two-year deal).
Plan beneficiaries who converted their inherited plan funds to an inherited Roth IRA could also recharacterize those funds back to an inherited IRA just like anyone else. But if they do that, they lose the option of ever converting those funds back to a Roth IRA because they now are an IRA beneficiary-and an IRA beneficiary cannot convert inherited IRA funds to an inherited Roth IRA.
* If clients decide to undo (recharacterize) their 2010 Roth conversion in 2011, how soon can they reconvert those funds back to a Roth IRA? They must wait until the calendar year after the conversion or more than 30 days after the recharacterization, whichever is later.
For example, if Mary converted $300,000 to a Roth IRA in 2010 and she later changes her mind (maybe because the value dropped or she simply does not want to pay the tax), she has until Oct. 17, 2011, to undo that Roth conversion. If she recharacterizes on Sept. 18, 2011, she can reconvert those funds after 30 days have passed from the date of the recharacterization (Oct. 18, 2011). The reason it's 30 days instead of the next year is that the conversion was a 2010 conversion and it's now 2011. Mary's already in the next year, so 30 days after the recharacterization is the later of the two dates.
If this were a 2011 conversion and Mary decided to recharacterize in August 2011, then she could not reconvert those funds until 2012, since that is the later of 30 days after the recharacterization or the year after the conversion.
* I know that clients can do partial Roth conversions, but can they do partial recharacterizations? Yes. In fact it often makes sense not to recharacterize the entire Roth conversion. Keeping some funds in the Roth IRA, even a very small amount, will start the five-year clock ticking for qualifying distributions.
Ed Slott, a CPA in Rockville Centre, N.Y., is a nationally recognized IRA distribution expert, professional speaker and author of several IRA books. He has also created programs developed specifically to help financial advisors become recognized leaders in the IRA marketplace. Visit his website at www.irahelp.com.
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