What is the Biggest Mistake U.S. Taxpayers Will Make Before Yearend?

The answer is: “Not fully considering the merits of a 2010 Roth IRA conversion”.  By our estimate, at least 50% of taxpayers should complete a Roth IRA conversion prior to yearend!  Why would so many taxpayers miss this opportunity?  Probably because they’ve been bombarded with so much complex and confusing advice they don’t fully understand the opportunity. 

BASICS:  The basic difference between a traditional IRA (including most retirement plans) and a Roth IRA is that traditional IRAs may receive a tax deduction for contributing to the IRA and the account grows tax deferred.  However, all of the proceeds are taxable when withdrawn from the traditional IRA account.  The IRS wants to get their share of taxes, so there is a Required Minimum Distribution (RMD) when the account holder reaches age 70 ½ and each following year.  For the Roth IRA there is no deduction for contributions made and, as long as the rules are followed, the money grows tax free and is distributed tax free.  An additional Roth IRA benefit is no RMD for a Roth IRA owner.  If the Roth money is not needed for living expenses, it can stay in the Roth IRA and be passed onto the beneficiaries while still maintaining all of the income tax free growth attributes. 

The Roth IRA conversion is a rare case of heads the taxpayer wins- tales the IRS loses!  The no lose opportunity results from the taxpayer’s option to undo the conversion prior to the 2010 tax filing deadline, generally October 15, 2011 for an extended return.  So once your 2010 tax return is nearly complete,  you can measure the tax cost of the conversion to determine if it still makes sense.  If the tax cost is too high compared to what you might pay by withdrawing your funds in a later tax year, simply reverse the conversion and it effectively never happened.  What about all the transactions costs incurred to complete the conversion that didn’t work out?  If done properly, there are no transaction costs.  The underlying investments in the IRA account can be moved into and out of the Roth IRA “in-kind”- no transaction or trading is required. 

Starting in 2010, all taxpayers qualify to make a Roth IRA conversion.  Under current law, taxpayers can complete a conversion each year in order to target that year’s taxable income.  Since taxpayers can’t lose, why wouldn’t all taxpayers complete a conversion every year?  Some taxpayers don’t have IRAs or may not have access to their retirement funds.  However, those that do should consider a conversion unless they are certain they will have an opportunity to withdraw IRA funds in later years at lower tax rates.  And since tax rates are scheduled to increase in 2011, now is the time to take a realistic look at your options. 

Here's a quick outline of situations where a conversion is a no-brainer:

• Due to the bad economy or other circumstances, I have no taxable income in 2010.
• I have after-tax funds in my IRA or qualified plan.
• My IRA investment has hit bottom and can only increase in value.
• I expect to have a taxable estate and my health is rapidly failing.
  

And circumstances that warrant a precautionary conversion:

• Due to my steady salary and future anticipated pension benefits, my marginal tax rate is unlikely to fall below 25%;  however, in 2010 I can incur an additional $20,000 of income before exceeding the 15% tax rate.
• Unless Congress extends current tax rates, I will be paying tax at the new 39.6% rate for the foreseeable future.
• I  might be willing to pay the tax now on my IRA if the IRA investment doubles in value in the next year where I’ll capture that growth tax free.
• I need to withdraw IRA funds and I want avoid the early withdrawal penalty before age 59 1/2.