Taxes are due on 2010 Roth IRA conversions

Fro USA Today -

Several years ago, Congress enacted a law that offered individual retirement account holders a deal that looked a lot like those "same as cash" offers you see in ads for furniture and appliances.

The law, which took effect Jan. 1, 2010, lifted income restrictions on Roth IRA conversions, allowing high-income taxpayers to convert to a Roth for the first time. It also gave IRA owners the option of delaying taxes on 2010 conversions by opting to split income from the conversion between 2011 and 2012.

Not surprisingly, a lot of people decided to defer taxes on their Roth conversions. If you chose that option, though, taxes on the first half of your conversion income are due this year. And like those "same as cash" offers, failure to pay by the deadline — which is April 17 — could leave you in a world of hurt.

Don't expect to get a notice from your IRA provider reminding you of your tax obligation. Instead, you need to refer to last year's tax records and your 2010 tax return, says Melissa Labant, tax manager for the American Institute of Certified Public Accountants. Assuming you opted to postpone your tax bill, the amount of income deferred will show up on Form 8606 of your 2010 tax return, Labant says. On line 25A, you should see the amount of income you're required to pay taxes on when you file your 2011 tax return, Labant says.

Most taxpayers will report the income on Line 16B of Form 1040, Labant says. Tax software will do this automatically. Keep in mind that the income from the conversion has been reported to the government, so if you fail to report it, "You're going to get a letter from the IRS," says Francis St. Onge, an enrolled agent in Brighton, Mich.

No turning back

Ideally, you should have prepared for this tax hit by putting aside money to pay the tax bill. Even if you did, you may be in for an unpleasant surprise when you do your taxes. A large conversion could push you into a higher marginal tax bracket, Labant says. It could also make you ineligible for some tax credits and deductions that phase out at specific income levels, she says. If you're retired, the additional income could force you to pay taxes on a portion of your Social Security benefits. "Anytime your adjusted gross income increases, there are negative consequences," Labant says.

Sadly, it's too late to negate the tax bill by reversing the conversion. Taxpayers have the option of undoing a Roth conversion through a process called recharacterization, but the deadline for recharacterizing a 2010 conversion was Oct. 15, says Maria Bruno, analyst for the Vanguard Group. "The bottom line is that the tax is due," she says. "There's not much you can do."

Another wrinkle for taxpayers who converted in 2010 is the expiration of the 2001 Bush tax cuts at the end of this year. Depending on a number of factors, including who wins the presidential election, some high-income taxpayers could end up paying higher taxes on the second portion of their 2010 conversion. Paying taxes on the entire conversion this year would protect you from that prospect, but it's not an option, Bruno says. If you elected to defer income on a 2010 Roth conversion, you're locked into a 50-50 split, she says.

Nowhere to hide

If you can't pay the taxes on your 2010 conversion, the worst thing you can do is fail to file your return, Labant says. That will trigger interest and steep failure-to-file penalties, she says.

Options for cash-strapped converters include a short-term credit card loan or an IRS installment plan. If you've run out of time and money, you can withdraw money from your Roth, but that should be your absolute last resort, says Ed Slott, author of The Retirement Savings Time Bomb and How to Defuse it in 2012. If you're under 59½, you may have to pay an early withdrawal penalty. You'll also end up paying taxes on money that's been growing tax-free, which defeats the purpose of converting to a Roth in the first place, he says.

Meanwhile, it's not too soon to start planning for next year's tax bill, St. Onge says. For example, you may want to adjust your exemptions to increase the taxes withheld from your paycheck.