by Ryan McKeown, CPA, CFP®, Vice-President Financial Advisor, Wealth Enhancement Group

2010 brings a unique opportunity to convert Qualified Plans or IRAs to Roth IRAs. First, those that make $100,000 or more of “Modified Adjusted Gross Income” are now eligible to make these conversions. Second, you have the ability to elect to include the amount you convert equally as income on your 2011 and 2012 tax returns.
 
If a conversion to a Roth IRA does make sense for your situation (make sure to visit with your advisor first!), the sooner you convert, the better off you potentially could be due to the earnings of the account after the conversion being tax free from that point going forward. If there are positive gains to be had in 2010, it would be much better if they happened after you convert than before you convert.
 
What happens if there are negative returns?  If you convert in 2010, you have the ability to re-characterize or “undo” your conversion until October 15th, 2011. This is important because you have to pay taxes on the amount that you convert, not on the account value afterwards. If you convert $100,000 to a Roth IRA in January 2010, but it is only worth $70,000 in September 2011, you could re-characterize that account back to an IRA and not have to pay taxes on the $100,000 you converted (why pay taxes on $100,000 on an account that is only worth $70,000?). Keep in mind that for any conversions that you make in 2010, you don’t have to pay the taxes until you file for 2011 and 2012 (meaning the taxes are due April 15, 2012 and April 15, 2013). It is good to make estimated payments if necessary to avoid penalties). That means that by the deadline you have to re-characterize by, you have not had to pay the taxes on that conversion yet.
 
With that being said, if a conversion to a Roth IRA makes sense for your situation, why not convert right now, knowing that if you have positive investment performance, your earnings will be tax free provided you meet the qualifications to do so?  If you have negative performance, you always have the option to re-characterize later on and not pay the tax on a depreciated account.
 
One other point to make on converting and making re-characterizing work out best for you:  perform Roth IRA conversions into different accounts, each with one holding (some will be more aggressive, some more conservative depending on goals, objectives, and risk tolerance). That way, if some holdings have negative performance, you can choose to only re-characterize those accounts and not pay taxes on your “losers.” It also means that you can keep your winners that may have had wonderful performance and you can continue to hold onto your “winners” and not pay any taxes on the earnings. After the deadline has passed to re-characterize your conversions, you can consolidate those separate accounts back into one Roth IRA so it is easier to manage your portfolio.
 
Our recommendation: don’t do this alone without professional assistance. Roth IRA conversions are like a great prescription drug advertisement. They can provide wonderful benefits if the drug fits your situation based on a complete professional evaluation and diagnosis. However, the side effects can be many if your entire financial picture is not taken into consideration.