Starting in 2010, the federal government has new rules that encourage converting a traditional IRA to a Roth IRA. This has been discussed ad nauseam throughout the financial media. However, one important consideration not usually discussed is the impact a conversion has on your state taxes. Here in Massachusetts converting a traditional IRA to a Roth IRA will also be subject to state income taxes. As such, the cost of this levy should also be considered.
Massachusetts tax law does not allow a deduction for contributions to a traditional Individual Retirement Account. (Why would Massachusetts want to allow a deduction and encourage something as frivolous as retirement savings?) If you convert your IRA account to a Roth IRA, the portion of your IRA account relating to contributions previously taxed in Massachusetts will not be subject to state income tax. However, untaxed contributions as well as any accumulated earnings and appreciation in your IRA will be subject to the 5.3% Massachusetts income tax. Under the federal guidelines, you will be allowed to pay any tax on this conversion in the current year, or defer it and pay half in 2011 and half in 2012. This two year payment option has also been adopted in Massachusetts.
Here are two examples as provided by the Massachusetts DOR:
"A taxpayer eligible to make a 2010 rollover, has a $20,000 traditional IRA, which is comprised of $10,000 of contributions that were deducted for federal purposes but subject to Massachusetts tax, and $10,000 of accumulated earnings or appreciation. If the taxpayer rolls over the traditional IRA into a Roth IRA, the entire $20,000 would be included in federal gross income in the taxable year beginning in 2010. However, the taxpayer may elect to defer the inclusion in federal gross income ratably over the two succeeding taxable years: $10,000 for the taxable year beginning in 2011 and $10,000 for the taxable year beginning in 2012.
Section 2(a)((3)(A) of chapter 62 provides that only the portion of the rollover previously not subject to Massachusetts taxation, in this case, the $10,000 of earnings and appreciation, will be included in Massachusetts gross income in 2010. If the taxpayer elected to defer payment of federal income tax, the taxpayer must also defer the inclusion in Massachusetts gross income ratably over the two succeeding taxable years: $5,000 for the taxable year beginning in 2011 and $5,000 for the taxable year beginning in 2012."
In my case, much of my IRA account is a rollover from a 401(k) account. I did receive a deduction in Massachusetts for these contributions. As such, if I chose to convert to a Roth IRA, the entire amount of the conversion will be subject to Massachusetts income tax of 5.3 percent. This is a big consideration. If you are planning on moving to a no income tax state upon retirement, i.e. Florida or New Hampshire, you may not be subject to state income taxes upon drawing of the IRA accounts. Consequently, a conversion may subject you to Massachusetts income tax now where as not converting you may not be subject to state income taxes at all.