Extension of Income Tax Rates Gives Taxpayers Interest-Free Loan

The extension of income tax rates essentially gives taxpayers an interest-free loan if they convert an IRA into a Roth IRA by December 31. Taxpayers who converted in 2010 expected rates to rise next year, forcing them to report all the additional income on their 2010 returns. Now that the tax rates will not rise for two years, savers should defer the income to 2011 and 2012, using that money to earn something in the interim. Conversions work best for taxpayers who know they’ll be in as high or higher tax brackets in later years.

There’s a potential additional benefit for New York taxpayers. New York income tax rates rose to 8.97% in 2010 and are scheduled to fall back to 6.85% in 2012. Thus, New York taxpayers may be able to defer the income from conversions until a year with lower income tax rates.

Investors who convert have until October 2011 to undo the conversion, minimizing the risks associated with this technique.

For more information on the benefits of converting in 2010, see Alexis Leondis, Tax Passage Gives U.S. Wealthy Interest-Free Loans for Roth IRA Transfers, Bloomberg, Dec. 17, 2010.

Special thanks to Jim Hillhouse (WealthCounsel) for bringing this to my attention.