By Ken Berry
The other shoe is about to drop for hundreds of thousands of taxpayers who converted from a traditional IRA to a Roth in 2010. And the IRS is likely to catch it. In fact, it has just posted a reminder to 2012 filers and their tax return preparers about these obligations on its website (IR-2013-21).
First, let’s go back in time to 2010. That was the year that the floodgates finally opened for Roth IRA conversions. Previously, you could convert funds in a traditional IRA to a Roth IRA only if your modified adjusted gross income (MAGI) didn’t exceed $100,000. But a 2006 tax law change removed the restraint based on MAGI, beginning in 2010. So many upper-income taxpayers were able to take advantage of this opportunity for the first time.
The attraction is obvious. Although there are no tax deductions allowed for contributions on the front end, qualified distributions in the future are tax free. For this purpose, “qualified distributions” include payouts from a Roth in existence at least five years that are either made after attaining age 59½, due to death or disability or used for first-time homebuyer expenses (up to a lifetime limit of $10,000).
Of course, you must pay tax on a conversion at ordinary income rates, but it’s still worth the price of admission for many taxpayers, especially those who expect to be in a higher tax bracket in retirement. The benefits on the back end often outweigh the up-front cost.
To spice up things even further, for a Roth conversion in 2010 – and 2010 – only the tax was deferred and split evenly over the following two years. In other words, you had to pay tax on half of the converted amount in 2011, and now you must pay the other half of the deferred tax on your 2012 return. This tax deferral was automatic unless you opted to pay the full amount of the tax due on your 2010 return. Similarly, if you chose to recharacterize your Roth back to a traditional IRA, you don’t owe any deferred tax in 2012. But the deadline for recharacterizations of 2010 conversions is long past.
The IRS says that taxpayers who didn’t receive any distributions in 2010 or 2011 of any amount from a 2010 Roth conversion must report the amount from line 20b of 2010 Form 8606, Nondeductible IRAs; on line 15b of 2012 Form 1040; or Line 11b of 2012 Form 1040A. On the other hand, if a taxpayer received a distribution in either 2010 or 2011, he or she may be able to report a smaller taxable amount for 2012.
Don’t forget to inform clients about their tax responsibilities relating to 2010 Roth conversions. You don’t want them to be unpleasantly surprised when you complete their returns.