From the February 2010 issue of Boomer Market Advisor • Subscribe!

Roth conversion is not an investment decision

You have probably been inundated with endless advertisements and articles touting 2010 as a banner year for the financial advisory business. All of this is due, we are told, to the lifting of the AGI limitation for Roth IRA conversions. Roth conversions are a great tool for your kit, but they are not the answer for everybody. The most important thing to remember is that the Roth conversion is not an investment decision--it is a tax decision--and there are ways to make the tax decision a lot easier for retiring business owners in 2010.

When you convert a regular IRA or other qualified assets to a Roth IRA, the converted amount gets taxed as ordinary income in the year of conversion (assuming that all the original assets were funded with pre-tax money). A large conversion can create a hefty tax bill, and most of the strategies surrounding Roth conversions are intended to minimize this tax. Converters get a break as the law allows taxpayers to stretch the tax liability over a two year period, half in 2011 and half in 2012. Business owners have another tool in their belt, however--the NOL.

NOL is short for "net operating loss," and business owners may be eligible to claim it on their federal tax return in a year that their business costs and expenses exceed their business income. NOLs are usually associated with running a business. Taxpayers who are in partnerships, limited liability companies (LLCs), or S-Corporations generally don't get to use NOL--their losses are generally claimed as business losses subject to the passive activity rules.

A NOL is easy to report--it gets entered on line 21 of Form 1040 (Other Income) as a negative number. If a taxpayer has an especially large NOL in a tax year, they can carry it back and apply it against taxes paid in the last two years (by amending their returns) up to the amount of their NOL. Any "leftover" NOL can be carried forward for up to 20 years to offset future income. If current and future taxes are more of a concern, taxpayers can waive the "carry-back" period and use the NOL only on future tax years.

The benefit that NOL provides for retiring or soon-to-be-retired business owners is the flexibility to control their taxable income during the Roth conversion process. Say a retiring business owner has a $50,000 NOL in 2009, and she wants to convert her solo-401(k) to a Roth in 2010. Now she has a few options--she could use the entire NOL amount in 2010 to offset up to $50,000 of her Roth conversion, creating a net conversion tax of zero. If her 401(k) is larger than her NOL, she also has the option of spreading the taxation of the Roth conversion over the next two years.

Although doing a Roth conversion is not suitable for everybody, if a taxpayer has had a few tough years in their business just before retiring, they may still be able to make some lemonade from those lemons.

Mark A. Cortazzo, CFP is senior partner with MACRO Consulting Group in Parsippany, N.J.

Reprints Discuss this story
This is where the comments go.