Many of you have heard about the possibility of converting your traditional IRA into a Roth IRA. As most of you know, traditional IRAs grow tax deferred, although on the withdrawal of amounts from the IRA the taxpayer recognizes ordinary income that he must pay income tax on.

 In contrast, Roth IRAs grow tax free and are withdrawn without the recognition of income. While the government allows certain taxpayers to convert a traditional IRA into  a Roth IRA, there is usually the current recognition of the traditional IRA income to do so. Moreover, the government imposes strict income requirements, in that if you make too much income, you cannot convert. The catch-22 in the whole concept is the very act of converting results in higher income, thereby reducing the chances that you qualify for the conversion.

 There is an upcoming window, however, lifting these income limitations. Converting to a Roth IRA may result in significant tax advantages. Allow me to illustrate this by example.

 Assume Bob wishes to convert his $500,000 IRA into a Roth IRA. He chooses to do so in 2010 and must pay income tax on that amount. Assume that Bob pays $150,000 of marginal income tax on the transfer. Bob should have the tax payment available from other resources so that he can transfer the full amount from the traditional IRA into the Roth IRA.

 With this new law, Bob can defer the $150,000 payment into $75,000 payments to be paid in 2012 and 2013 as I explain below.

 Assuming a 7% return on his Roth IRA compounded over fifteen years that money has grown to almost $1.4 million. Bob now has that pot of money to withdraw over his life expectancy and pay no more income taxes on those withdrawals. In essence, Bob paid $150,000 of income tax between now and 2013 to have the ability to withdraw $1.4 million (plus further appreciation) over time tax free.

 Today I’m going to give you a timeline so that you can meet with your advisors to better prepare should you believe converting your traditional IRA into a Roth IRA makes sense.

 January 1, 2010 – Income restrictions on conversions to a Roth IRA are lifted. Anyone converting to a Roth IRA in 2010 may elect to have the income taxed equally in 2011 and 2012, or they may report all of the income for the 2010 tax year.

 December 31, 2010 – This is the last day to make a Roth conversion distribution for the 2010 tax year. Conversions made after this date do not qualify to spread the income over later years. Taxes will be owed fully in the year of the conversion after 2010.

 January 31, 2011 – Taxpayers must be sent IRS Form 1099-R by this date, which reports any distribution from an IRA, including conversion distributions.

 April 15, 2011 – Taxpayers must file their income tax returns for the tax year 2010, or extension requests, by this date.

 May 31, 2011- Taxpayers must receive IRS Form 5498, reporting any contributions to an IRA (including conversions into a Roth IRA) by this date;

 April 16, 2012 – Income tax returns, or extension requests, must be filed for tax year 2011. If a taxpayer carried out a conversion to a Roth IRA in 2010, and did not report the income in 2010, then they must report 50% of the conversion income as part of their adjusted gross income for 2011.

 April 15, 2013 – Income tax returns, or extension requests, must be filed or tax year 2012. If a taxpayer carried out a conversion to a Roth IRA in 2010, and did not report the income in 2010, then they must report the remaining 50% of the conversion income as part of their adjusted gross income.

 Hope this helps your income tax planning. As always, consult with your own tax professionals before acting.

 ©2009 Craig R. Hersch