In 2009, only taxpayers with modified adjusted gross income (MAGI) of $100,000 or less may convert a regular IRA to a Roth IRA. However, beginning in 2010, the $100,000 MAGI limit on conversions to Roth IRAs will be eliminated, and taxpayers may roll over amounts in qualified employer sponsored retirement plan accounts, such as 401(k)s and profit sharing plans, as well as regular IRAs, into Roth IRAs regardless of adjusted gross income.

Why is a Roth IRA attractive? Benefits include:

  • Earnings within the Roth IRA are tax-deferred in the same manner as a regular qualified plan.
  • Unlike a regular qualified plan, distributions from a Roth IRA generally are not subject to income tax.
  • A Roth IRA owner does not have to begin lifetime required minimum distributions (RMDs) after he or she reaches age 70 ½ as is the case with regular qualified plans.
  • Beneficiaries of Roth IRAs withdraw earnings tax-free.
  • Upon conversion from a regular qualified plan to a Roth IRA, the rollover will be fully taxed. If you make a rollover to a Roth IRA in 2010, you may elect to pay half of the income tax due in 2011 and half in 2012 – or you may elect to pay the entire amount in 2010. You will be paying tax now for the future privilege of tax-free distributions and no required distributions.

Why pay all of the income tax in 2010? Absent Congressional action, for calendar years after 2010, income tax rates will revert to levels in place prior to the 2001 Tax Act. In other words, the top four tax brackets could go back to 39.6%, 36%, 31%, and 28%, instead of the current 35%, 33%, 28%, and 25% brackets.

Converting to a Roth IRA now and paying income tax next year or over the next two years, flies in the face of the adage, "defer, defer, defer." If you convert now, you will be bearing the income tax on retirement plan assets rather than your beneficiaries. When retirement accounts are subject to both estate AND income taxes, what your non-spouse beneficiaries actually receive may be cents on the dollar.

Whether or not you should consider a rollover to a Roth IRA depends on a number of factors, such as:

  1. Can you pay the taxes on the rollover with funds from nonretirement accounts? If you use retirement plan funds to pay the income taxes, less will be available to accumulate tax-free within the account. Consider the investment return on regular plan assets versus the investment return on Roth IRA assets that may need to be liquidated to pay for the income taxes attributable to the rollover.
  2. Do you anticipate being in a higher income tax bracket in the future? Given the state of the current economy and federal deficit, tax rates for upper middle income and high income taxpayers may increase in future years.
  3. Do you have time before you need to use your Roth IRA? The more time that passes between the rollover and distributions to you will allow you to recoup the income taxes paid on the rollover. The future tax-free Roth IRA distributions may more than offset the income taxes paid on the rollover.
  4. Are you willing to pay a tax price now for the opportunity to pass on tax-free income to your beneficiaries later?

Here are some steps you can take now to prepare for the 2010 rollover opportunity:

  • If you are still able to make deductible IRA contributions in 2009, you should do so. You will reduce your 2009 tax bill and, if you convert to a Roth IRA next year, you can defer paying back the tax savings until 2011 and 2012.
  • Some taxpayers may plan to make large conversions in 2010 but defer payment of income tax until 2011 and 2012 because of the uncertainty of increasing income tax rates. In this case, you might consider avoiding the standard acceleration of year-end deductions and deferring income and, instead, take actions to defer deductions and recognize income in 2009 in an effort to avoid being pushed into the highest brackets by a large 2010 IRA-to-Roth-IRA conversion.
  • If you have never opened a regular IRA because you were not able to make deductible contributions, consider opening a regular IRA this year and make the largest allowable, nondeductible contribution you can afford. If you convert the regular IRA to a Roth IRA in 2010, you must include in gross income only that part of the amount converted attributable to income earned after the IRA was opened. In 2010, you can roll over the regular IRA into a Roth IRA. Please note that if you previously made deductible IRA contributions, or rolled over a qualified plan to an IRA, complex rules determine the taxable amount.

In addition to having the option to defer income tax payment on a conversion between tax years 2010 and 2011, you may also recharacterize a Roth IRA back to the regular IRA if the Roth does not perform well in the year of the rollover. The deadline for recharacterizing is the tax return deadline for the year in which the initial conversion was made. For example, if you roll over in 2010 and things do not go well, you can "reverse" the rollover (and the tax consequences of the conversion) prior to April 15, 2011.

You and your tax advisors should consider your entire financial situation prior to considering a rollover to a Roth IRA in 2010. In addition, there are a number of details to consider beyond the scope of this article.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.