Traditional to Roth IRA conversions: Don’t be tripped up by tax implications

Another good overview from The Boston Globe.

By Humberto Cruz
When you try to oversimplify tax matters, you often commit inaccuracies. I’ve found plenty, from slight to gross, in the nearly incessant media commentary about Roth IRA conversions. No wonder readers are confused.

As of this year, anybody with a traditional IRA can convert all or part of it to a Roth IRA. A Roth IRA offers the potential for future tax-free withdrawals. But if you convert, you will owe income taxes on the converted amount the same as if you withdrew the money from the traditional IRA (but with no 10 percent penalty, regardless of age).

That’s where the first inaccuracy creeps in. Many reports I’ve read state that if you convert, you will be taxed “upon conversion.’’ That phrase has led many readers to believe that as soon as you make a conversion you must send a check to the IRS for the taxes due on that conversion.

Not so. The taxable amount of the conversion simply counts as taxable income for the year. How much of the converted amount is taxable will depend on whether your traditional IRA includes nondeductible contributions.

If you have little additional income and enough exemptions and deductions, a small conversion may cost you little or even nothing in taxes.

But a big conversion can be expensive if the additional taxable income pushes you into a higher tax bracket and/or makes you ineligible for certain tax credits. You may be required to pay quarterly estimated taxes to meet your tax liability and avoid a penalty.

Another common inaccuracy is the assertion, and I quote, that “taxes from a Roth IRA conversion in 2010 can be split between 2011 and 2012.’’

The facts: If you convert in 2010, you can either report all the taxable income from the conversion on your 2010 tax return or report half of it on your 2011 return and the other half on your 2012 return. (You may not, as many readers believe, report one-third of the income for 2010, one-third for 2011, and one-third for 2012). The option to split the income exists for 2010 conversions only.

So, in reality, you may not have to start paying the taxes from a 2010 conversion until 2012, when you file your 2011 tax return.

Another inaccuracy is that it is the taxable income from the conversion and not the actual tax that may be split between the two tax years, said Kim Saunders, a tax analyst for Thomson Reuters.

“This seems a pretty important point to clear up,’’ an observant reader wrote. A large converted amount one year may push a taxpayer into a much higher tax bracket and result in a large tax bill that could be reduced by splitting the income. But a risk of income splitting is tax rates may go up for 2011 and 2012.

A decision on when to declare the income from a 2010 conversion does not have to be made until you file your 2010 return, Saunders said. By then, tax rates for at least 2011 will be known.

Vermont tax repeal effort draws controversy

News for our neighbors to the north.

Burlington, Vermont - February 7, 2010

As the Vermont legislature struggles to find $150 million worth of budget cuts this year, an attempt to roll back two tax increases is running into opposition. At issue are the capital gains and estate taxes, primarily affecting upper income Vermonters. But there's evidence that the two taxes are driving wealthier residents out of state to places like Florida.

The Vermont senate Economic Development committee met at Burlington city hall last week to hear testimony on repealing last year's increases on the state capital gains tax and the estate tax. Although farms were excluded from the death tax, as critics call it, the two taxes together raise tens of millions of dollars a year. And tax advisor Rick Wolfish told the panel the higher taxes are driving out high-income Vermonters.

"That is exactly what is happening," he told the panel, "that people are leaving the state. And CPAs and professionals are advising them."

Last year, the legislature lowered an exclusion on the estate tax from $3.5 million to $2 million. Tax experts say it's not just big Wall Street investors who get hit. Any Vermonter who built up a small business can get hit at anything over two-million of net assets, upon his or her death.

Wolfish said, "Under current law, if a taxpayer is considering the sale of a business, why not move to another state before the sale and pay no Vermont on the sale whatsoever?"

Real estate developer Ernie Pomerleau agreed. He said, "You know, there are people who can survive this, there are people who just say enough is enough. I can live someplace else."

Pomerleau has invested millions in Vermont development projects, creating jobs in the process. He says he'll never leave Vermont. "I'll die with my boots on here," he said. But Pomerleau said he knows others who already have left. "I know three dozen colleagues that are gone," he told the senators. "And I know you'll hear 'one comes in, one goes out.' The ones that go out have been here for forty years creating jobs, philanthropic, part of the energy of this community."

The legislature raised estate and capital gains taxes to help close a looming budget deficit as Vermont was losing 20,000 jobs along with a lot of income tax revenue. One Progressive policy advisor says the state simply cannot afford to restore a capital gains tax break. Doug Hoffer testified, "We have four years of data from when the capital gains exclusion was adopted, in those four years it cost us over $150 million. Now, the highest year was $51 million in a single year. That's a big hole to fill."

But supporters of the tax repeal say the question comes down to whether high state taxes are killing the goose that laid the golden egg. Still, the fact that the economic development committee is the only legislative committee to take up the repeal indicates how difficult that is likely to be.

Andy Potter -- WCAX News

IRS Silent So Far On New US Tax Rules For Inherited Wealth

Our trusts are drafted in such a way to account for the change, but still going to be an interesting time figuring it all out.

By Martin Vaughan, Of DOW JONES NEWSWIRES

WASHINGTON -(Dow Jones)- The U.S. Internal Revenue Service is taking a wait- and-see approach on issuing guidance dealing with taxes on inherited wealth, unsure whether Congress will act in the next several months to change the rules again.

Advisers to the wealthy say they are left without a roadmap on a number of issues related to the disposition of assets left behind by those who have died since Jan. 1. In particular, they are looking to IRS for rules on how a new capital gains-tax regime that took effect this year will apply to estates.

"There are no forms that give us any idea how or what we are supposed to report," said Stephen Litman, an estate planner at the Minneapolis law firm of Leonard, Street and Deinard. "This leads to significant administrative challenges for families."

Congress is weighing whether to set permanent rules for taxing estates, and whether to make those rules retroactive to the beginning of this year, but such action is weeks, and maybe even months, away.

The 2001 tax-cut law was aimed at gradually eliminating estate taxes, but repeal proponents at the time lacked the congressional majorities needed to do so permanently.

As a result, the federal estate tax was repealed for 2010 only, and is scheduled to return in 2011 at rates similar to those in effect prior to President George W. Bush's tax cut legislation.

In place of the estate tax for 2010 is a capital gains tax that is levied when assets are sold. Heirs would have to pay capital gains taxes on the full appreciation in value of the asset from the time it was acquired by the deceased benefactor, a concept known in tax circles as "carryover basis."

That means that families have an additional step of searching records to establish the basis value of the asset, which was unnecessary when estate taxes were in place.

"Carryover basis rules have added another level of complexity," said Carol Kroch, head of wealth and financial planning at Wilmington Trust Corp. "Families will have to go through a more difficult process of valuing assets."

The 2010 law provides that heirs can get a "step-up" in basis, meaning no capital gains taxes would be due if the asset is immediately sold, for up to $ 1.3 million of the estate property. Surviving spouses can get a step-up in basis for an additional $3 million in property.

Families will have to decide which assets to protect from capital gains taxes with the basis step-up. For example, property that is to be sold in the near future might be a good candidate, to avoid an immediate tax consequence. It might also be wise to protect property that has been in the family for a long time, and therefore has a low basis, wealth advisors say.

All that said, Congress might pass legislation that reinstates the estate tax for 2010 and eliminates the carry-over basis rules, which would make all such planning moot.

That may explain why IRS for now is waiting for the legislative picture to come into focus.

"We are currently looking at the issues involved to determine the best course of action," said IRS spokesman Bruce Friedland.

Families generally have nine months from the death of the estate owner to file estate tax returns, so there is a little breathing room before they have to make decisions about how to allocate assets.

"I don't think anyone would be distributing assets yet," said Kroch. "Over time, estate executors will have to make a decision about how much to hold in reserve for the estate tax" in case Congress re-imposes it retroactively, she said.

Another option that is getting some discussion by congressional staff is an election that would allow the family members of people who died between Jan. 1, 2010 and when new legislation takes effect to choose between paying estate taxes, for example at the rates in effect in 2009, or the capital gains-tax regime under the current law.