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By Editor, January 6, 2011

Background

Before 2010, there was an often-unavoidable stumbling block for higher-income individuals who wanted to implement the Roth IRA conversion strategy. In those years, conversions were prohibited for folks with Modified Adjusted Gross Income (MAGI) in excess of $100,000. For 2010 and beyond, the MAGI restriction is history. The rule that made individuals who use married filing separate status ineligible for Roth IRA conversions is also history for 2010 and beyond. Thanks to the demise of these restrictions, 2010 was “the year of the Roth IRA conversion”. For taxpayers that made the conversion, the story is not over. In fact, 2011 is when the rubber meets the road for 2010 conversions.

2010 Converters Must Decide When Conversion Income Will Be Recognized

2010 converters can spread the taxable income triggered by 2010 conversions evenly over 2011 and 2012 (50% in each year) for federal income tax purposes and thereby defer the tax hit. In fact, this defer-and-spread deal happens automatically unless the taxpayer makes the alternative election to recognize all the conversion income in 2010. [See IRC Sec. 408A(d)(3)(A)(iii) .]

Going with the defer-and-spread deal is not a no-brainer. For example, if you believe you will pay a lower marginal tax rate in 2010, it might make sense to recognize all the conversion income in 2010 by reporting it on that year’s Form 1040. As we just explained, making that choice will require an election with the 2010 return.  As this was written, we did not have any details about how to make the election. We will tell you as soon as we know more.

No general rule of thumb can be offered for whether to recognize the income for 2010, or spread it over 2011 and 2012. Each taxpayer’s situation must be considered individually.

2010 Converters Have until 10/17/11 to Reverse Ill-fated Conversions

Another “safety valve” for Roth IRA conversions is the fact that converters are allowed to change their minds well after doing the deed. Any 2010 converter has until the extended due date for filing his 2010 Form 1040 to recharacterize the converted amount back to traditional IRA status. The extended due date for 2010 returns is 10/17/11 (for calendar-year taxpayers). A recharacterization reverses the earlier conversion and eliminates the related tax liability. The 10/17/11 deadline for reversing 2010 conversions applies whether or not the converter actually extends his 2010 Form 1040. [See IRC Sec. 408A(d)(6) and (7) and Reg. 301.9100-2(b) .]

Example: Fred converted two traditional IRAs into two Roth IRAs in 2010. In 2011, the values of the converted accounts plummet due to poor investment performance. In this bleak scenario, Fred would have to pay income tax on value that later disappeared. Bad idea! Thankfully, he has until 10/17/11 to reverse the 2010 conversions by recharacterizing the two Roth IRAs back to traditional IRA status. After the reversal, it’s as if the ill-fated conversions never happened. So, Fred won’t owe any tax on the now-reversed conversions.

Side Note: Regardless of whether taxpayers are 2010 converters, doing any 2011 conversions early in the year makes some sense because clients will have until 10/15/12 to reverse any ill-fated 2011 conversions. That’s almost two years to see how things go. Of course, if 2010 converters also do 2011 conversions, it puts extra variables in play regarding the best time to recognize income from the 2010 conversions.

Why 2010 Converters Should Extend Their Returns

There are two big reasons for 2010 converters to extend their 2010 returns to 10/17/11.

• First, it creates extra time for converters to decide if they are better served by: (1) going with the defer-and-spread deal that results in spreading the conversion income evenly between 2011 and 2012, or (2) making the election to report all the conversion income in 2010. Converters should have a better handle by next October on how much income they expect to have in 2011 and 2012. We hope and trust that the IRS will provide timely guidance not only on how to make this election, but also allowing it to be made on a timely filed extended return.
• Second, extending their 2010 returns will make it much easier for converters to handle any reversals of 2010 conversions. If the converter’s return is extended, the reversal is reported by simply showing no income from the now-reversed conversion on the original 2010 Form 1040. Simple! If the 2010 return is not extended and a 2010 conversion is reversed after the filing date, an amended 2010 return will have to be filed to report the reversal. Not so simple!

Conclusions

Doing Roth IRA conversions in 2010 made lots of sense for certain taxpayers, but the book is still open because decisions about 2010 conversions must be made in 2011. First and foremost, 2010 converters should consider to extending their returns to create extra time to make those decisions.