There are almost as many ways to perform the analysis on Roth IRA conversions as there are reality TV shows about celebrity brat children these days… The point of this article is to make certain that any calculation you’re doing with regard to a Roth Conversion treats the tax appropriately. In reviewing whether or not a Roth IRA conversion in 2010 makes sense and furthermore whether you should spread the tax over the next two years, you need to consider what the tax cost is for a conversion in 2010, weighed against the costs you’ll experience if you spread the tax over 2011 and 2012. Unfortunately we often shortcut the analysis by only taking the marginal rate on the income including the conversion and calculate the tax – this would give you an erroneous result, since our tax system includes graduated tables.  I’ll illustrate this below.

How to Properly Calculate the Tax

The only way to ensure that you are working the tax numbers out correctly is to work through the operation as if it were on your tax return.  The table below shows a simple example of an individual with a fixed income contemplating a Roth Conversion of $75,000 paying the tax in 2010, and the second and third columns analyzing paying the tax in 2011 and 2012.

	2010	2011	2012
“Normal” Adjusted Gross Income (AGI)	$80,000	$80,000	$80,000
Roth Conversion	$75,000	$37,500	$37,500
Total AGI with conversion	$155,000	$117,500	$117,500
Standard Deduction	-11,400	-11,500	-11,600
Personal Exemptions	-7,300	-7,400	-7,500
“Normal” Taxable Income	$61,300	$61,100	$60,900
“Normal” Tax	$8,358	$8,325	$8,292
Taxable Income w/conversion	$136,300	$98,600	$98,400
Marginal tax rate	25%	25%	25%
Actual Tax (with conversion)	$26,437	$17,000	$16,938
Difference in tax	$18,080	$8,675	$8,645
Actual rate on conversion	24.11%	23.13%	23.05%
Total tax on conversion	$18,080	$17,320
Effective rate on conversion	24.11%	23.09%

Since the marginal rate for the example is 25% for all three years, you might mistakenly believe that 25% is the rate that you should apply to the entire conversion, which would give you an erroneous result.  Since the Actual Rate on the conversion is just a bit lower for the spread years versus 2010, there is an advantage to spreading the tax instead of paying it in 2010.  It’s not a huge difference, $760 in this example, but it’s a difference nonetheless. Keep in mind that this is only an example, and that the 2011 and 2012 tax tables and other provisions are guesses at best.  But the point is that you shouldn’t make assumptions about tax costs for conversions and the spread option – it’s best to make sure that you work your way through the returns to see the results in the “real world”. In addition, this particular analysis is only reviewing the tax cost to help decide whether spreading the tax over 2011 and 2012 is beneficial – there are a great many other factors to consider when doing analysis of a Roth Conversion beyond this.  Make sure your analysis is thoroughly considering all of the factors before proceeding.  And get professional help if you need it.

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