Note to Readers:  This article is part of an occasional series on personal finance topics that may be useful for a broader audience than The Rational Walk’s typical focus on value investing.  This is not intended to provide specific tax advice.  Consult with your accountant for solutions specific to your personal finances.

While many of us are still working on our 2009 tax returns, it is never too early to begin planning strategies for the current tax year.  2010 provides an unusual number of opportunities to reposition assets in ways that can minimize taxes for decades to come.  One of the more interesting opportunities involves converting traditional IRA assets into a Roth IRA.

Traditional vs. Roth

Traditional IRAs allow taxpayers to make annual contributions of $5,000 ($6,000 for those over 55) which can be deducted against current year income for lower income taxpayers or those who are not covered by a retirement plan at work.  Assets within a traditional IRA compound on a tax deferred basis until funds are withdrawn in retirement.  At that time, the withdrawals will be taxed at income tax rates prevailing at the time.  In addition, taxpayers are forced to begin withdrawals in the year after reaching 70 1/2 years of age.

Roth IRAs permit annual contributions in the same amount as traditional IRAs for single taxpayers earning less than $105,000 and married taxpayers earning less than $166,000.  Contributions are not deductible against current income.  Roth IRA assets compound on a tax free basis and withdrawals in retirement are tax free.  Unlike traditional IRAs, owners of a Roth IRA are never required to take withdrawals during retirement.

2010 Roth Conversions

A Roth conversion occurs when a taxpayer who owns a traditional IRA re-characterizes all or part of the IRA into a Roth IRA.  The taxpayer would normally owe current year income taxes on the funds that are converted into the Roth.  However, in the future all of the benefits of a Roth IRA will apply.  Prior to 2010, taxpayers earning over $100,000 per year were not permitted to make conversions.  However, in 2010, any taxpayer is permitted to make the conversion.  Even better, the taxes that would normally be owed in 2010 can be paid in two equal installments for the 2011 and 2012 tax years.

In general, tax advisors recommend that taxpayers use funds from outside the traditional IRA in order to pay taxes.  If a taxpayer must use funds from the traditional IRA to pay taxes, the amount lost to taxes will not be available to compound within the Roth IRA.  Furthermore, taxpayers under the age of 59 1/2 will owe a 10 percent penalty on funds that are withdrawn to pay taxes.

Hedging Against Higher Taxes

The opportunity to convert traditional IRA assets into a Roth can provide an opportunity for investors to minimize the long term impact of taxes, particularly since rates appear to be moving toward higher levels in the coming years.  Here are a few potential scenarios where a Roth conversion could reduce long term tax burdens:

1. Higher income taxpayers may benefit from a 2010 conversion and could choose to pay taxes in 2010 rather than 2011/2012 in order to avoid anticipated higher tax rates after 2010.  While Congress may extend the Bush tax cuts for lower income taxpayers, it is nearly certain that the current 33 percent bracket will revert to 35 percent and the current 35 percent bracket will revert to 39.6 percent starting in 2011.  By converting into a Roth in 2010 and paying taxes at today’s lower rates, higher income taxpayers can avoid paying taxes on traditional IRA distributions at higher rates in the future.
2. Those who are not in tax brackets that are likely to increase in 2011 can make a conversion in 2010 and strategically spread the income over 2011 and 2012 in a way that avoids being bumped into higher tax brackets.  One danger of making a large conversion is that it can have the effect of temporarily reaching higher tax brackets if done in any one year.  2010 offers the opportunity to spread out the tax burden over two years while also potentially avoiding a temporary move into higher brackets.
3. Retirees and others in the 15 percent tax bracket can make annual Roth IRA conversions strategically sized to “use up” their 15 percent tax bracket and minimize the required minimum distribution from Traditional IRAs in the long run.  For example, a taxpayer who has income that results in paying taxes at the 15 percent level may not have fully exhausted the bracket with normal income.  A traditional IRA conversion to a Roth could fully exhaust the bracket while falling short of breaching the 25 percent bracket.

The dire fiscal situation of the United States is likely to lead to much higher taxes in the future, particularly on those who are in higher tax brackets.  Recent health care legislation broke precedent by subjecting certain types of investment income to Medicare taxes for higher income taxpayers.  While it appears that retirement plan distributions will not be subject to the Medicare tax, this could change in the future.  Of course, there is always the risk that the government may try to break its pledge to treat Roth IRA distributions as tax free for higher income taxpayers.  However, this seems less likely than moves to tax investment income outside retirement accounts.