IRA Conversions: What’s Special About 2010?

As all us personal finance geeks know, 2010 is a special year with regard to converting your traditional IRA to a Roth. For the benefit of non-geeks who have accidentally brought up this blog on their browser, it is worth explaining1040 that there are actually two separate changes in the rules that kicked in on January 1, 2010.

The first is that from now on there is no income limit for doing a conversion. In the bad old days, to be eligible you needed to have an income of less than $100,000. Today anybody with a traditional IRA can convert it to a Roth, and this is true for all future years, not just 2010. (Unless, of course, Congress changes the rules again.)

The second IRA conversion change for 2010, and the one that makes 2010 "special" is that if you convert during 2010, and only during 2010, you have the option of deferring the income from the conversion to 2011 and 2012. So if you convert $100K from your traditional to Roth, you have the choice of either increasing your taxable income by $100K in 2010 or by $50K in both 2011 and 2012.

Everything else equal, that is an interest-free loan from the government. Instead of paying the taxes on your conversion on April 15, 2011, you can put it off to April 15, 2012 and 2013. Cool.

Alas, that "everything else equal" phrase is a gotcha. It is only an interest-free loan if the tax rates you would pay in 2010, 2011, and 2012 are the same. If the rates were higher after 2010, then it might be a pretty expensive loan after all.

Well, guess what? Income tax rates will rise in 2011. We think.

As the law currently stands, the Bush tax cut package turns into a pumpkin at midnight December 31, 2010 and we will revert to the pre-cut rates. It is widely assumed that this will not happen, that some of the Bush cuts will be saved by new legislation, but as of right now we are on track for full expiration. Below is a table of 2010 income tax rates for a married couple filing jointly and the projected 2011 rates assuming no new legislation.

 

Income Between 2010 Rate Current 2011 Rate
0 – $16,750 10% 15%
$16,751 – $68,000 15% 15%
$68,001 – $137,300 25% 28%
$137,001 – $209,250 28% 31%
$209,251 – $373,650 33% 36%
$373,651 + 35% 39.6%

 

The consensus assumption, based largely on Obama campaign promises, is that the first four brackets will be saved and that only those greedy bastards making more than $209K will face higher rates. That sounds likely to me, but there is the minor complication that this will "cost" the government $1 trillion over ten years.

But even tax hikes that start at $209K can be a serious issue for those considering a Roth conversion. Imagine a married couple with a $100K traditional IRA and a household income of exactly $209,250. If they convert, they can pay $33K in additional taxes for 2010 or $36K split between 2011 and 2012. That works out to be the equivalent of a 6% loan. Not a terrible rate, but not the hoped for interest-free deal.

The problem, of course, is that an IRA conversion is treated as additional income. For folks with a decent amount of money socked away that means that the conversion will get them briefly categorized as rich by the rule makers in Washington. And that, in turn, may mean that deferring the tax otherwise due in 2010 is a bad deal after all.

So for some people, the special 2010-only aspect of IRA conversions, that you can defer the tax hit, turns out to be not so special. Abolishing the income ceiling is useful, but that’s (presumably) permanent. As it turns out, what may make 2010 special is that it is the last time we will see marginal rates for the top brackets, the brackets in which a conversion might fall, so low.

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