Roth Around the Clock

I remain a big fan of the Roth conversion – that is converting a traditional IRA into a Roth.  Still it’s worth noting that if you converted to a Roth in 2010, the time to change your mind about that move ends on October 17^th of this year.  The reason to convert in the first place is a belief that you’ll pay less tax on the money in the IRA if you pay taxes now rather than when you are forced to take minimum distributions of that money.  (IRAs defer taxes, but they don’t prevent them.)  If anything has happened since 2010 to change that belief, now is the time to act.    

When you convert an IRA you have to pay the taxes Uncle Sam didn’t collect when you first salted that money away.  In 2010 our Uncle was feeling generous, so he provided the option to pay those taxes over two years.  Also, there are income restrictions that stop some people from contributing to a Roth (For 2011, Adjusted Gross Income of $179,000 if married filing jointly, $122,000 for singles and $107,000 for married filing separately).  A rollover though, is open to everyone.  So if you think the Roth version of tax deferral is good for you, but can’t qualify for regular contributions, conversion is a back door that remains perpetually open.   

The problem is the time lag between the conversion and the tax payment.  Let’s say when you cashed out of the IRA in 2010 the value of your account was higher than it is now.  If you stay put, you’ll pay taxes on money you may never get to spend.  Given the recent market volatility this is not just an academic argument.  The other area of risk is the protracted recession has put financial pressure on people who might not have expected to be short on funds when tax bills come due in 2012.  For those folks the idea of paying the taxes early may still look good, but may be impractical.

 You are allowed to undo or “recharacterize” the conversion.  You can put the funds back in an IRA.  If you made the move in 2010 though, the clock is ticking.  The Wall Street Journal article on this topic says Vanguard Group had a 423% increase in conversions in 2010 and Fidelity reported similar results.  If you recharacterize, the money goes back into a traditional IRA.  You can change your mind a second time, but you can’t reconvert in the same year you “unconverted” (I’m not sure that’s actually a word, but presumably context communicates the meaning).  If you’ve already filed your 2010 return, you’ll have to amend that as well as deal with the 2011 paperwork. 

The Journal article goes on to say that the conversion levels in 2011 were way down, and the number of recharacterizations hasn’t spiked despite the reasons to think they might.  The thought is that people who had the wherewithal to pay all those taxes in 2010 are generally still doing well enough to handle the commitment.  Also, the same market volatility that can cause one to recharacterize can raise the value of the account when you’re required to take minimum distributions and increase your tax bill yet again.  If you’re interested, there are more details about this on my most visited website (sad but true) http://www.irs.gov, look for Publication 590. 

One other “gentle reminder” in terms of dates…  October 15^th is drop dead for filing individual 2010 taxes.  No exceptions.