2009 vs. 2010 Roth IRA Conversion

Let me share with you a real-life issue presented by a reader: He has a traditional IRA which he would like to convert to a Roth IRA. His 2009 modified Adjusted Gross Income is under $100,000 so he can do it this year. Or he can do it in 2010, regardless of his AGI. Remember, if he does the Roth conversion in 2010, that’s the year of the IRS’s Great Roth Sales Event. You have the option of spreading the taxable income from a 2010 conversion over two years, 2011 and 2012, as described in February 28’s post. So which is the better option?

Here are the considerations we came up with:
• There’s always the possibility that Congress changes the law and eliminates or restricts Roth conversions beginning in 2010. So that factor favors the 2009 conversion. Grab it while you can.
• Some people harbor the fear that some time in the future a deficit-strapped Congress will renege and make Roth IRA distributions (or part of them) taxable. I personally don’t think that’s very likely. But, hey, you never know. But that gets to whether any Roth conversion is wise, not when to do it. So, that’s a push.
• What are your tax brackets in 2009, 2011, and 2011? A low tax bracket year is a factor favoring the Roth conversion in that year.
• If you expect to have high income in 2011 or 2012, you can’t ignore the possibility of a tax rate increase, as has been proposed. And if you are thinking about converting a large IRA, the conversion itself will make you a high-income person for that year.
• If you expect your IRA to grow with investment earnings, that growth favors doing the Roth conversion now. Waiting nine months until 2010 will increase the amount of income that’s taxed in order to get a given portion of your IRA converted.
• The IRS’s Great Roth Sales Event in 2010 favors waiting until 2010. You get the benefit of a bit of tax deferral. How much is that worth? I ballpark it as making a Great Roth Sales Event conversion about 7.5% cheaper than a regular 2009 conversion, assuming the same tax brackets in 2009 as 2011 and 2012. Here’s where I get that number: In 2010, the IRS lets you defer half the taxable income for one year, and half for two years. That’s an average of 1.5 years’ deferral. Add another year of tax payment deferral you get by waiting for 2009 to turn into 2010. If you invest the expected tax cost in a tax-exempt money market fund, you might project 3% per year return. So that works out to a 7.5% discount on the tax.
• How does that 7.5% discount compare to your projected growth in the IRA over the next nine months? If you’ve got your IRA invested in fixed income investments, that factor favors waiting until 2010, since your IRA is not likely to grow by that amount in nine months. On the other hand, if your IRA is invested in equities, it’s been hammered pretty hard over the last 17 months. Is it time for the turnaround we’re all dreaming about? Ask yourself, are you feeling lucky?
• Here’s an important bit of advice. Whenever you do the Roth conversion, whether it’s March 2009 or during the IRS’s 2010 Great Roth Sales Event, estimate your tax cost based on the market value of the converted IRA and invest that conservatively while you wait for tax payment day to roll around. Particularly if you’re taking advantage of the 2010 Sale. Payment may be delayed, but the tax will soon be due. You don’t want to get whipsawed by investing the IRS’s interest-free loan in equities, which then go down in value before tax bill date arrives.
• There might be another factor that comes into play. If you delay the conversion until 2010, how will you be investing the money that's outside your IRA for the next nine months? The arithmetic three bullet points ago assumed it’s invested in a tax-exempt money market. But what if you’ve got it invested in equities, or in the same mix of equities and fixed income as your IRA? (The caution urged in the last bullet point gets triggered by the Roth conversion, but doesn’t necessarily apply while you’re waiting nine months to convert.) That tends to increase the breakeven rate of growth at which the 2009 conversion beats the 2010 conversion.

So which is better, 2009 conversion or 2010 Great Roth Sales Event conversion? Bottom line, nobody knows. If you can think of a factor I’ve left out, please post a comment or send me an email. TheTwoLeggedStool@gmail.com.