Have Code, Will Travel

June 12, 2010

2010 Roth IRA Conversion Tips and Tricks

Filed under: Roth IRA Conversion — Phil Sandler @ 9:48 am
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(Update: someone asked me if I could post this in Excel format.  It’s linked at the bottom.  It took me about 5 minutes compared to ~45 with WPF.  Right tool for the job?  🙂 )

(Disclaimer: I am not a tax professional, and you should absolutely do your own due diligence on all the information provided below.)

Kind of an odd thing to be posting on a blog that is supposed to be about .Net and SQL, but since (1) I’ve been obsessed with figuring out the best way of doing it and (2) since I actually wrote an app to do a specific calculation to help me figure it out (yes, I’m a nerd), I thought I would share.

There are about a million articles out there explaining the new law, and the special provisions for 2010.  There are about another thousand that include calculators showing the value of converting vs. not converting, and the general advantages of the Roth vs. the Traditional IRA.  I don’t have a lot to add to those topics, but the basics are:

  • The Roth IRA is generally a better deal than the Traditional IRA except in very specific cases.
  • Starting in 2010, conversions of Traditional IRAs to Roth IRAs will be allowed, regardless of income. This will be the case until the law changes again, so 2010 is *not* the only/last chance to take advantage of this.
  • Any money converted will be considered income, so you will need to pay the taxes out of non-retirement funds in the year of the conversion.
  • However, a special provision allows you to convert the money in 2010 and have it considered as income in BOTH 2011 and 2012 (50-50 split) to ease the tax burden in any one year.

As I said, I am not an expert on taxes or politics, but my non-professional opinion is that income taxes are very likely to go up in the near future and are not likely to be this low again for a long time.  So converting as much as possible as soon as possible seems like a smart financial move.   At the same time, the tax burden on converting 100% of your Traditional IRAs could be substantial, and it probably isn’t worth the risk of completely draining your savings to take advantage of current tax rates.

Trick #1: a less known (but not secret) fact: you can re-characterize ("de-convert") a converted Roth IRA if you change your mind for any reason, as long as you do it before you file your taxes for the year of the conversion.  If the market tanks after you do the conversion, for example, and your IRA loses a lot of value, you are probably better off re-characterizing and not paying taxes on that money.  You can always re-convert the re-characterized IRA at a later time (after 30 days or in the next calendar year, whichever is later).

Trick #2: building on that, I learned very recently that converting and re-characterizing is allowable at the account level.  That means that you can choose to convert each and every fund that you have in your Traditional IRAs into a separate Roth IRA.  That would give you the flexibility to re-characterize only those funds that lose value, and keep the conversion on those that don’t.  One account per fund is probably overkill, but you get the idea–you could split your investments into separate accounts by investment type (foreign, domestic, bond, etc.).  After filing your taxes, you can combine your Roth IRAs back into a single account for easier management.

Trick #3: the best trick of all, and the subject of the calculator I put together, is a trick that allows you to convert in 2010 and split your tax burden over THREE years.  Unfortunately, you can’t take advantage of this if you’re single.  Because each individual may independently elect to pay income taxes on the conversion in 2010 or split the taxes across 2011 and 2012, you and your spouse may strategically elect to each choose a different option, effectively giving you the maximum flexibility to take advantage of the (relatively) low current tax rates.

The application was written using Windows Presentation Foundation (WPF) and Visual Studio 2010.  It will only run on Window platforms and requires .Net 4 (download) installed. I threw it together pretty quickly, so I don’t expect that it is completely bug-free.  If you see any problems, post them in the comments and I will do what I can to fix them.

Essentially you can change the total conversion amounts for both you and your spouse, and adjust the marginal tax rates you expect to pay in the years 2010, 2011, and 2012 (remember that state taxes should also be considered in this rate).  The application displays a grid of your tax burden for each year, and the total, for each of four strategies:

  • Paying all taxes in 2010
  • Paying all taxes split across 2011 and 2012
  • Paying taxes on your conversion in 2010, and splitting the taxes on your spouse’s conversion between 2011 and 2012
  • Paying taxes on your spouse’s conversion in 2010, and splitting the taxes on your conversion between 2011 and 2012

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