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.