Sunday, 2 October 2011

To Convert or Not Convert the IRA

This was the year long debate in our household. In 2010, the federal government dropped the income limit for moving savings from a traditional to a Roth IRA. Additionally, you had a one-time option to pay taxes on the current value of the converted funds over a two-year period. The converted asset then grows tax-free.

To get this tax break off any future earnings of the converted funds, you have to pay income tax on the value of the funds moved.

From Kelly Greene's Wall Street Journal article on 9.30.2011, "The federal government allows the tax-law equivalent of a do-over, says Maria Bruno, an investment analyst at fund giant Vanguard Group, whose customers converted more than 230,000 traditional IRAs to Roths last year, and which has processed 3,900 do-overs this year, as of Monday."

We are one of the 3,900 who converted back. This was a highly contested move in our household. Bob is sure with the current level of the national debt, that by the time we withdraw the retirement savings, we will be under the burden of a significantly higher tax rate. Kristy is pretty convinced we most likely will never retire so it will be a tax that our kids can cover when inheriting the asset. In the final hours.... Kristy won.

Investors who transferred traditional IRA holdings to a Roth in 2010 can move the funds back to a traditional IRA and avoid the tax up to October 17th. If you filed your 2010 tax returns already, you can amend them. We amended our tax returns last month. The weight of such an extra-large tax payment, even spread across a two-year time line seemed insurmountable to Kristy, given our number of other more short-term, family goals.

There were multiple steps to "reconvert", a waiting period, and then the "recharacterize" of the account as a traditional IRA. Calls to our tax advisor, calls to the IRA custodian...

The downside? We lose the one-time option for 2010 conversions of getting to spread the income involved across two tax returns. We lose out on the possible tax-free earnings of the converted fund. Up-side? Significant less tax to pay over the next two years.

Who was right? We will let you know in 30 years.

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