Convert IRA To Roth IRA In 2010?

Many of you probably know of the 2010 Roth IRA conversion loophole allowing taxpayers with very high incomes to gain access to all the tax benefits Roth IRA’s have to offer.  As always, of course, there’s a downside:  you have to pay income tax on the total amount of the conversion.  And since very high-earners are the one’s most likely to benefit from this loophole, it’s safe to assume many are in the very highest tax bracket.  Ouch.

Convert IRA To Roth IRA In 2010 Or Not?

The 2010 Roth loophole contains one particularly juicy little-publicized tidbit that makes  the prospect of converting to a Roth IRA much more enticing.  Indeed, the following provision was added by Congress specifically to tempt high-income taxpayers with large tax-deferred nest eggs to convert sooner rather than later in an attempt to boost short-term tax revenue (which I think is unwise, but that’s a story for another day).

If you choose to convert to a Roth in 2010, the IRS will allow you to spread out the taxes due on the conversion between 2011 and 2012, a huge benefit that isn’t available if you convert in 2009 (or any year thereafter except 2010).  Why is this so huge?  Assume you are in the highest federal income tax bracket (35%) and have a portfolio of just over $1,000,000 to convert.  If you paid taxes on the entire conversion in a single year, you would owe $350,000 in federal taxes alone.  That’s enough to make you think twice, isn’t it?

By spreading the tax burden out over 2 years, however, high-income taxpayers with large conversion amounts stand to benefit considerably.  In the example above, you would owe taxes on $500,000 in 2011 and $500,000 in 2012, which works out to $175,000 in federal taxes due per year.  Since you would be able to hold onto that $175,000 a year longer, you have the ability to invest and earn a return on it.  That $175,000 invested conservatively in a 12-month high interest CD paying 2% would earn an extra $3,500 risk-free.  Not a huge amount to be sure, but it’s free money.  You might as well take it.