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Have you considered converting funds from your Traditional IRA into a Roth IRA? If you’re a regular reader, you’re aware that the income limits for Roth IRA conversions went away this year. What I haven’t talked about as much are the tax consequences of such conversions.
To make a long story short, you’ll have to pay taxes on any tax-deferred funds that you convert. This includes any pre-tax (i.e., tax-deductible) contributions that you’ve made as well as any earnings that your IRA investments have generated.
The catch is that the IRS will look at all of your IRAs (Traditional, SEP, and SIMPLE) as one big pot of money when determining taxable amounts. Thus, if you have a mix of deductible and non-deductible contributions, you can’t just cherry pick the dollars that would minimize your tax burden.
Example: You have a SEP-IRA with $5000 in tax deferred funds (deductible contributions + earnings) along with a Traditional IRA with $4000 in non-deductible contributions plus $1000 in earnings.
In this case, 40% of the holdings ($4k out of the $10k total) have already been taxed, so 40% of your conversion would be tax-free. This is true regardless of which account(s) the money actually comes from.
That’s the bad news. The good news is that, as long as you do the conversion in 2010, you have the option of deferring the tax burden until 2011 and 2012. If you do this, you will pay taxes on 50% of the conversion in 2011 and the remaining 50% in 2012.
Given that income tax rates are generally expected to increase in 2011 with the expiration of the Bush tax cuts at the end of this year, you’ll have to decide for yourself whether or not this is a good idea.
A couple of other considerations…
Do you have enough cash on hand to pay the taxes on the conversion? If you’re under 59.5 years of age and you use any of the cash that you take out of your to cover the tax burden, you’ll have to pay a 10% early distribution penalty. Not good.
Will booking the entire conversion during 2010 push you into a higher tax bracket? If so, then it might be better to wait even if income tax rates increase next year. Again, you’ll have to run the numbers and see what’s best in your specific case.
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