2010/2011 Split Roth Conversion

Submitted by Don Lloyd on Wed, 2009-06-24 10:36

Assuming the following simplified conditions, what possible benefits, if any, might derive from the ability to pay 2010 Roth conversion taxes 50/50 in 2010 and 2011?

Single, all income and living expenses from post conversion Roth IRA and SS, full Roth conversions to fill out bracket in every year (maybe $25K/yr, for example. if no split), minimal investment gains

Thanks, Don



Submitted by Joseph Arsenault on Wed, 2009-06-24 14:14

Without seeing your tax return it is impossible to tell you what benefit will be derived from spreading the income recognition over two years. You should consult your tax preparer or CPA about it if your considering it.

Generally speaking, it is usually advantageous to spread your income our (defer it) because of the progressive tax rate schedule. The more income you have in one year, the higher tax bracket you are in. Your effective tax rate increases with an increase in taxable income. Unless you expect YOUR tax bracket to raise in 2011, you would probably benefit from recognizing the conversion income over 2011 and 2012. You need to consult a professional to determine if there is a benefit for you.

-j



Submitted by Don Lloyd on Wed, 2009-06-24 15:51

Monsta,

My bracket won’t change because I will always fill the bracket with Roth conversions. I’m looking for any possibility that there would be a difference inTY2011 between a new $25K conversion and paying the last half of the tax on the $50K 2010 conversion. Conceivably the carry-over might interact with the taxes on my SS benefit differently, although it seems unlikely. If I had a high return untaxed investment in my Roth, it would make sense to get $25K into it a year earlier, but other than that I’m coming up empty. Maybe it is only an advantage if you empty your Traditional IRA.

Thanks, Don



Submitted by Joseph Arsenault on Wed, 2009-06-24 16:14

I see what your saying. You basically want to figure out how much income you have left to recognize in your current tax bracket before stepping up, and you will convert that amount.

I just noticed an error in your post though. The income is recognized in 2011 and 2012 if you elect to defer.. So it would be difficult to decide how beneficial the election would be. Say you had 25k of income to fill out in 2010, well if you elect to defer the income, it will be included in 2011 and 2012, and you will still have the 25k hole in 2010. You would need to have an idea of how much income you would want converted in 2011 and 2012, and then you convert that total in 2010 and elect to defer it. Considering the tax rates and income ranges are going to change, that may be difficult.

I believe you either elect to defer all of it, or recognize all in 2010, i don’t think you can do a partial election (although the form and form instructions are not available yet).

It is much easier to give definitive answers on this when the tax returns and relative documentation is in front of you as everyone’s situation is unique.

Some of the factors to consider based on what you are saying:

the conversion income is part of your social security inclusion formula
your suspected taxable income in 2010, 2011, 2012
current and future tax rates and tables
cash flow considerations
Which assets will be used to pay the conversion tax (inside or out)

Normally deferring the income is advantageous, but you should consult a professional in person who can look at the optimal (most tax efficient way) for you to convert your Traditional IRA assets.

Hope that helps some

-J



Submitted by Anonymous (not verified) on Wed, 2009-06-24 16:16

Just to clarify the conversion rules for 2010:
You have two options:
1. Pay all the taxes in 2010
2. Spread equally over 2011 and 2012.
YOU CANNOT CHOOSE TO SPLIT BETWEEN 2010 AND 2011.

I haves seen these rules misquoted in many articles on the internet already.



Submitted by Joseph Arsenault on Wed, 2009-06-24 16:26

Thanks pko.

This was my understanding but I had not had anyone ask about breaking it up.

-J



Submitted by Don Lloyd on Wed, 2009-06-24 17:17

Monsta,

[i]I just noticed an error in your post though. The income is recognized in 2011 and 2012 if you elect to defer..[/i]

I don’t understand ‘elect to defer’.

I have only two sources of taxable income, Social Security and Roth conversions. The Social Security will effectively be the same for 2010 and 2011 and will be taxable in the year received. I am assuming that a $25K Roth conversion in each of the years 2010 and 2011 exactly fills out a marginal tax bracket for both years. This filling out of the bracket depends in part on the SS benefits paid, but it is the same for both years. The question is whether the tax effect in TY2011 is any different for a 2011 $25K conversion as compared with a $25K carryover from a TY2010 $50K conversion. In neither case will the Traditional IRA come close to exhaustion.

Thanks, Don



Submitted by Joseph Arsenault on Wed, 2009-06-24 17:35

Why are you thinking 25k will be carried over to 2011? Converting 50k in 2010 will not allow you to recognize 25k in 2010 and 25k in 2011. Perhaps I am misunderstanding what you are trying to accomplish.

If you convert in 2010, you have the option “election” to recognize 50% of the income in 2011 and 50% in 2012. That is what I was referring to and thought you were referring to because you talked about carrying over the income.

If your simply looking at the difference between converting 50k in 2010, or converting 25k in 2010 and 25k in 2011, you would need to consult your accountant to project the estimated difference in taxation.



Submitted by Don Lloyd on Wed, 2009-06-24 18:09

Monsta,

[i]If you convert in 2010, you have the option “election” to recognize 50% of the income in 2011 and 50% in 2012.[/i]

Ok, now we have difference of opinion in facts. Can you reference this?

It has always been true that a Roth conversion in TYXXXX is taxable in year XXXX and must be paid for by 4/15 in year XXXX + 1. My assumption has been that your statement should be ‘recognize 50% of the income in 2010 and 50% in 2011’. Am I wrong?

Thanks, Don



Submitted by Anonymous (not verified) on Wed, 2009-06-24 18:21

This may help. It’s how TIPRA was written:
(you can find the original regs online somewhere; sorry don’t have the time right now)

http://en.wikipedia.org/wiki/Tax_Increase_Prevention_and_Reconciliation_…
scroll down to 2.6.7

pmk



Submitted by Don Lloyd on Wed, 2009-06-24 18:38

pmk,

Thanks.

[i]…Taxpayers who convert in 2010 may, as a special case, elect to pay tax on amounts converted in equal installments in 2011 and 2012.[/i]

This is certainly different than what I expected, but is still ambiguous. I read this as nothing more than a payment delay, but is the first payment due with the normal April 2011 tax payment for TY2010, or a year later, or not attached to tax payments at all?

Regards, Don



Submitted by Anonymous (not verified) on Wed, 2009-06-24 19:30

Well, even though I have a lot of experience with IRA rules, I would answer in the following way:

It appears that the IRS will actually give the taxpayer a break (delay), which means that a conversion in 2010, if elected to spread between 2011 and 2012 will actually mean no tax is due in 2010. It may be earmarked on the 2010 return through some entry on the 8606, since the 1099R will be issued in Jan. 2011 for 2010. Otherwise the IRS will not know why you did not report it in 2010. You will need to wait how they formulate the instructions on Tax Form 8606.

This is most logical explanation, I personally have.

pmk



Submitted by Joseph Arsenault on Wed, 2009-06-24 19:56

pmk, thanks for helping out

Here is a technical explanation copied directly from CCH Tax with the code cited.

“However, if the conversion occurs in 2010, unless a taxpayer elects otherwise, none of the gross income from the conversion is included in income in 2010; half of the income resulting from the conversion is includible in gross income in 2011 and the other half in 2012. The election is irrevocable after the due date for such taxable year. No provision was made for tax years after 2010, thus the taxable amount of a conversion contribution from an employer’s plan in taxable years beginning after 2010 to a Roth IRA will have to be included in the tax year the distribution takes place. [ I.R.C. §§ 408A(d)(3)(A)(iii), as amended by TIPRA (Pub. L. No. 109-222)] [ I.R.C. §§ 408A(d)(3)(A)(iii), 408A(d)(3)(E)(i), as amended by TIPRA]”

The 8606 may be used to show the Roth conversion (contribution / basis), but i think there might be a new form for the actual election. Not sure about that yet though. Some of the other people on the board may know..

Don,

once you digest this, let me know if you have any other questions.

-j



Submitted by Alan Spross on Wed, 2009-06-24 21:24

The actual reporting mechanics have not been released yet. But since the default will be the two year deferral, it seems logical to think that the 8606 will be designed to allow taxpayer to “opt out” of the two year deferral.

With respect to Don’s question, it may add clarity to re state the two year deferral without referring to taxes, but rather taxable income. The 2010 conversion with deferral does NOT figure a tax bill for the conversion, it simply results in half the taxable portion of the conversion to be added to AGI in 2011 and the other half in 2012. I understand that the recharacterization deadline for a 2010 conversion remains 10/15/2011 whether taxpayer opts out of deferral or not. When this date approaches the taxpayer should have a good idea of his 2011 income, but a much wider variance could be expected for 2012. In addition, many of the Bush tax cuts expire at the end of 2010, meaning that the brackets and rates could be re structured for 2011 AND 2012. I don’t know how much comfort a 15% bracket taxpayer can take in Obama’s promise that their taxes will not be increased, but at least some. A taxpayer retains more control by opting out and doing separate conversions in 2010, 2011 and 2012, even though tax cash flow takes a hit.

You can pretty well bank it that there will be no SS COLA for 2010, or a negligible one. 2011 has only slightly better prospects right now. There has also been no recent proposals to change the AGI thresholds for including SS in AGI, so I would not count on that. What cannot be predicted is what the investment market will do. Converting two years worth in Jan, 2010 will get the funds in the Roth sooner, but the amount total converted will be less than one year’s worth done in each of the 3 years. The 3 equal conversions is similar to dollar cost averaging for the tax benefit, but again, each conversion can be recharacterized in full or in part. Even if you don’t know what you will do in January, 2010, why not convert two years worth. 21 months later you can make the final decision of opting out and recharacterizing half that conversion. If there have been good gains, you can also opt out but NOT recharacterize even though you might spill over into the higher tax bracket for half the conversion. If the gains are good enough, you may still be ahead of the game.

In married, one spouse can opt out and the other defer. That could result in even better results if each has a retirement account to convert. But an individual cannot pick and choose between different conversions. If you do 3 conversions in 2010, you must defer or opt out of all 3 in total.

As pointed out by monsta, this will also require intense planning and decision making at various critical deadline dates, the largest of which will be 10/15/2011. We also need to be remain alert to any reporting surprises when the IRS releases the reporting details. The IRS has been known to occasionally come up with rulings that surprise those who have analyzed the legislation.



Submitted by Don Lloyd on Thu, 2009-06-25 00:26

Alan,

Thanks. It would appear that without a strong investment option, that the deferral will be inferior even without tax uncertainty. The only other possibility is if the option could be partial, taking $75K in 2010 and paying taxes on $25K in all three years, 2010-2012.

Regards, Don



Submitted by Alan Spross on Thu, 2009-06-25 01:11

Don,
Not always. If all you need to convert can be done in two tax years, and total taxable income for 2011 and 2012 will still fall in the right bracket for that taxpayer, the 2010 deferral works very well. But for those converting incremental amounts over a series of years eg in the 15% bracket, it might be best to opt out and just to that year to year because it not only utilizes the 2010 bracket, but provides more control over variables that otherwise could change.

One bad scenario would be deferring and then having an income windfall in 2012 that along with the conversion and usual income results in the conversion being taxed at a higher rate than planned. Once 10/15/2011 passes there is no escaping the higher tax bill, even if the conversion itself were to take huge losses. That conversion income was irrevocable determined by 10/2011. Not only would your taxes be higher, but you also might end up with your Medicare Part B premium being heavily surcharged two year later.

There are also some interesting options in either deferring SS retirement benefits or even returning previously collected benefits in order to get delayed retirement credits. Conversions can be more tax effective if you can avoid the bubble tax rate effect while 85% of SS income is added to your AGI. While the formula is adding SS to AGI, your actual marginal rate for 15% taxpayers becomes 27.75 (1.85 X 15%) or 46.25% for the 25% bracket. This inflates the true cost of the conversion. On the other hand, doing the conversion can reduce future RMDs and in later year prevent some of your SS from being taxable. SS income is the toughest variable to plan around because it occurs only at one level of total income, a level that fewer and fewer avoid totally because the formula is not indexed.



Submitted by Don Lloyd on Thu, 2009-06-25 03:00

[quote=”[email protected]“]Don,
Not always. If all you need to convert can be done in two tax years, and total taxable income for 2011 and 2012 will still fall in the right bracket for that taxpayer, the 2010 deferral works very well. But for those converting incremental amounts over a series of years eg in the 15% bracket, it might be best to opt out and just to that year to year because it not only utilizes the 2010 bracket, but provides more control over variables that otherwise could change.

One bad scenario would be deferring and then having an income windfall in 2012 that along with the conversion and usual income results in the conversion being taxed at a higher rate than planned. Once 10/15/2011 passes there is no escaping the higher tax bill, even if the conversion itself were to take huge losses. That conversion income was irrevocable determined by 10/2011. Not only would your taxes be higher, but you also might end up with your Medicare Part B premium being heavily surcharged two year later.

There are also some interesting options in either deferring SS retirement benefits or even returning previously collected benefits in order to get delayed retirement credits. Conversions can be more tax effective if you can avoid the bubble tax rate effect while 85% of SS income is added to your AGI. While the formula is adding SS to AGI, your actual marginal rate for 15% taxpayers becomes 27.75 (1.85 X 15%) or 46.25% for the 25% bracket. This inflates the true cost of the conversion. On the other hand, doing the conversion can reduce future RMDs and in later year prevent some of your SS from being taxable. SS income is the toughest variable to plan around because it occurs only at one level of total income, a level that fewer and fewer avoid totally because the formula is not indexed.[/quote]

Alan,

Thanks. You’ve pretty much covered the waterfront with this post. With the vast majority of my IRA being traditional, I need all three years of conversions to eat. Also, the effective bracket that I end up filling is close to 30% before the State (MA) is included. As you note, the phase-in (out?) of the SS taxable income drives the effective marginal tax rate to near-confiscatory levels. What I haven’t figured out yet is if it might be worth converting above the level where the 85% SS tax has been reached and the base marginal rates on conversions are no longer magnified by SS.

I don’t remember if I had a Roth choice when I was working, but it would have been the choice to make. OTOH, never making a non-deductable IRA contribution (if that’s the right desc.) was a good choice that kept the record-keeping requirements from driving me totally insane.

Thanks, Don



Submitted by Alan Spross on Thu, 2009-06-25 03:15

For many people there is some room within the 15% bracket after 85% of SS has been included. If you are going to pay the 27.75% for the conversion amount that brings in the SS, you would probably be happy to fill up the rest of your bracket at only 15%, plus MA of course. In fact, there might be cases where converting in alternate years where you pay more at 25% but less at 27.75% would pay off. The best thing is to get tax software and enter different scenarios. Of course, you could work the perfect plan and the markets could ruin things after the recharacterization deadline or Congress could pass a value added tax which would dilute the benefit of a Roth. No guarantees, but the less that you pay for the converted amounts the more the odds favor you.

Look at the Roth as a tax hedge against personal financial success, while maintaining a full TIRA hedges against bad things like losses, lawsuits etc. Not being clairvoyant, having a measured balance in each type makes good sense.



Submitted by Robert Wright on Thu, 2009-06-25 15:52

[quote=”alan-oniras”]The actual reporting mechanics have not been released yet. But since the default will be the two year deferral, it seems logical to think that the 8606 will be designed to allow taxpayer to “opt out” of the two year deferral.

With respect to Don’s question, it may add clarity to re state the two year deferral without referring to taxes, but rather taxable income. The 2010 conversion with deferral does NOT figure a tax bill for the conversion, it simply results in half the taxable portion of the conversion to be added to AGI in 2011 and the other half in 2012. I understand that the recharacterization deadline for a 2010 conversion remains 10/15/2011 whether taxpayer opts out of deferral or not. When this date approaches the taxpayer should have a good idea of his 2011 income, but a much wider variance could be expected for 2012. In addition, many of the Bush tax cuts expire at the end of 2010, meaning that the brackets and rates could be re structured for 2011 AND 2012. I don’t know how much comfort a 15% bracket taxpayer can take in Obama’s promise that their taxes will not be increased, but at least some. A taxpayer retains more control by opting out and doing separate conversions in 2010, 2011 and 2012, even though tax cash flow takes a hit.

You can pretty well bank it that there will be no SS COLA for 2010, or a negligible one. 2011 has only slightly better prospects right now. There has also been no recent proposals to change the AGI thresholds for including SS in AGI, so I would not count on that. What cannot be predicted is what the investment market will do. Converting two years worth in Jan, 2010 will get the funds in the Roth sooner, but the amount total converted will be less than one year’s worth done in each of the 3 years. The 3 equal conversions is similar to dollar cost averaging for the tax benefit, but again, each conversion can be recharacterized in full or in part. Even if you don’t know what you will do in January, 2010, why not convert two years worth. 21 months later you can make the final decision of opting out and recharacterizing half that conversion. If there have been good gains, you can also opt out but NOT recharacterize even though you might spill over into the higher tax bracket for half the conversion. If the gains are good enough, you may still be ahead of the game.

In married, one spouse can opt out and the other defer. That could result in even better results if each has a retirement account to convert. But an individual cannot pick and choose between different conversions. If you do 3 conversions in 2010, you must defer or opt out of all 3 in total.

As pointed out by monsta, this will also require intense planning and decision making at various critical deadline dates, the largest of which will be 10/15/2011. We also need to be remain alert to any reporting surprises when the IRS releases the reporting details. The IRS has been known to occasionally come up with rulings that surprise those who have analyzed the legislation.[/quote]

Alan,

What exactly do you mean by “opting out” in the following sentence from the above post?

“Even if you don’t know what you will do in January, 2010, why not convert two years worth. 21 months later you can make the final decision of opting out and recharacterizing half that conversion.”



Submitted by Alan Spross on Thu, 2009-06-25 18:59

The default rule for 2010 conversions is the two year deferral, so if taxpayer does nothing the income is deferred to 2011 and 2012. Opting out refers to the option of declining the two year deferral and reporting the entire conversion in 2010. The deadline date for this decision is 10/15/2011 which is the same date as the recharacterization deadline (the extended due date).

Therefore, if you plan originally to convert two years worth in 2010, lets say 50,000 with 25,000 reported in 2011 and 25,000 in 2012, but when doing your 2010 tax return you realize that you would rather use your lower bracket on the 2010 return, you could recharacterize half the conversion AND opt out. That will leave you with a 25,000 conversion reported in 2010. Then you would convert another amount in 2011 and 2012, this using all 3 years and possibly converting 75,000 in total over those 3 years rather than just 50,000. This example would of course apply to different numbers and percentages of recharacterizations.



Submitted by Robert Wright on Fri, 2009-06-26 12:31

Thanks Alan.
I don’t know if you get paid to monitor this forum, but you should get a bonus for all the good work you do.



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