Humberto Cruz

I sense much confusion -- and a tinge of regret -- among many readers who converted their traditional IRAs to Roth IRAs this year and now fear the tax impact will be much greater than they first thought.

Fear not. If you conclude that making the conversion was a mistake, you have ample time to undo it. If you decide to stick with it, you have options to deal with the tax consequences.

Before going on, a refresher is in order.

With a traditional IRA or individual retirement account, contributions can be tax deductible but then withdrawals will be fully taxable. With a Roth IRA, contributions are never tax deductible but withdrawals can be tax-free.

For the lengthy and complex details on who can contribute and how much, and what is taxable and what is not, you can download Internal Revenue Service Publication 590 from the IRS Web site, www.irs.gov.

Starting this year, anybody with a traditional IRA was allowed to convert part or all of it to a Roth IRA, regardless of income or filing status. Converting -- as millions of Americans have done -- allows for future gains in the IRA to be tax-free in exchange for being taxed on the converted amount.

I am confident most people who converted understood this trade-off. But many may not have realized that the converted amount can make their income for the year so high that they suffer other negative consequences.

Say, you converted a $75,000 fully deductible traditional IRA to a Roth IRA this year.

If you add the $75,000 to your other taxable income for 2010, you most likely will get bumped into a higher tax bracket (or even two brackets higher).

Depending on how high your income goes, you may also start losing itemized deductions, personal exemptions, tax credits and other benefits, or may be trapped by the alternative minimum tax. Too high an income can also cause as much as 85 percent of Social Security benefits to be taxed, and future Medicare Part B and Part D premiums to increase.

Again, details are too lengthy and complex to get into here. I just want to warn you about unanticipated consequences and the need to understand them fully or get professional tax advice.

Fortunately, a conversion can be reversed any time up until the deadline for filing the tax return for the year in which it was made, including automatic extensions, provided you file your return or extension request on time by April 15.

If you converted in 2010, you can reverse the conversion as late as Oct. 17, 2011 (the normal tax filing deadline for those requesting extensions, Oct. 15, falls on a Saturday next year). Converting and undoing a conversion -- the latter called a "recharacterization" in tax jargon -- are merely paperwork transactions with your IRA custodian.

If you stick with the conversion, you have a one-time option this year that could lower the tax impact.

Rather than report the entire converted amount as 2010 income, you can report half of it as income for 2011 and half for 2012.

In our previous example, you could report $75,000 of income in 2010, or $37,500 in 2011 and $37,500 in 2012. (There are no other options. You may not, as some of you think, report one third of the converted amount each in 2010, 2011 and 2012.) Reporting half the income at a time may keep you in a lower bracket and lessen the overall tax hit, but you risk that tax rates may rise in the future.

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Personal Finance - You Still Have Time to Reverse IRA Conversion

© Humberto Cruz