Converting to a Roth IRA is not new, so what with all the buzz about about this Roth IRA Conversion event in 2010? What makes it such a big deal is that up until then, most people couldn’t convert to a Roth IRA because their income was too high. For example, in 2009 if an individual or married couple have an AGI of over $100,000 the conversion is not an option. But in 2010, all that changes and that’s what makes it that exciting. Many people who have been salivating on the tax free benefit of the Roth IRA will finally get to sink their teeth into it.
Before I get into the rules on the Roth IRA Conversion, I want to give a quick reminder of why you need to open a Roth IRA account today: Tax Free Money. Is there anything else I need to say? Don’t just take my word for it, though. J.D. from Get Rich Slowly has a great post on his blog, “Why I Love the Roth IRA“. I couldn’t agree more. There are plenty of reasons to love the Roth IRA.
One stat that startles me is that the Roth IRA only accounts for 5% of all the retirement plans being used. How could something some great be so heavily under utilized? One factor is the income phaseout limits and the other is that consumers don’t fully comprehend how great the Roth IRA really is.
If you are one of the ones that doesn’t understand it, here’s a post I wrote that discusses the Roth IRA Rules that should help break down some of the basic concepts. After you’ve read that, here are some articles that can help you open a Roth IRA for the first time and the best place to open a Roth IRA account. Both good and helpful reads to get a beginner started. Now you don’t have any excuses for not having a Roth IRA.
If you couldn’t open a Roth IRA because you earned too much, you now have a chance to convert all traditional IRA’s, old SEP and SIMPLE IRA’s, and old 401k’s, 403b’s and 457 accounts in 2010. This creates an exciting opportunity for those that have been on the outside looking in on the benefits of the Roth IRA.
Consider 2010 as everyone getting their VIP access to the tax free party of the year….scratch that…..decade. Now that you are on board, let’s look at some of the tax ramifications of converting.
The one thing to be knowledgeable about is that we will have an income tax consequence due to this action, but congress has implemented a favorable tax treatment upon doing this. Usually if you convert from a traditional IRA to a Roth IRA, you are then burdened with the tax owed that current year, based off your ordinary income tax rate. The amount that is used to determine the tax owed is based on the actual day you convert.
But for anybody that converts in 2010, the tax laws allow you to defer your tax owed in 2010, to where you only have to pay half of the tax burden in 2011, and the remaining half in 2012. Essentially, that means you are spreading it out over a three year period.
2010 is the only year that this exception is allowed. Starting in 2011 (unless congress changes it), it reverts back to the original way where all the tax is owed in that year.
When it comes to converting, timing can be everything. The actual day that you convert is the value that is used to determine how much tax you will owe. The IRS does allow you to do a recharacterization, but doing so will prevent you from doing another conversion in that year. Many people who converted early in 2008 recharacterized when the markets began to tank in the fall. If you do decide you want to implement the “take back”, keep in mind that you have until October 15th of the calendar year following conversion to switch back to a traditional IRA.
Just because the conversion limit of $100,000 AGI is lifted, doesn’t mean that the income restrictions are lifted for new contributions into the Roth. If you’re over the phase out limits of the Roth IRA contribution, you will not be able to contribute new money to the Roth. However, there is a backdoor approach that allows you contribute to a non-deductible IRA and then immediately afterward convert it to a Roth IRA and avoid all taxable consequence. It’s a nice loophole that still allows you to continue to contribute to the Roth and benefit from the tax-free money. There maybe some special tax implications if you’ve contributed after-tax money into an IRA which I’ll discuss below.
Whether you are attempting to convert the non-deductible IRA or just a fraction of your old IRA’s, the IRS looks as them as one IRA. What will make a huge impact is whether you have a mixture of pre-tax and after tax contributions. Let me use a common scenario to illustrate the point.
Steven has a SIMPLE IRA, a Traditional IRA, and a Roth IRA totaling $160,000. Let’s breakdown the pre and post tax contributions of each.
|IRA Type||Current Value||After Tax Contributions||Pre-Tax Contributions|
Steven wants to convert only half of the amount in his SIMPLE and Traditional IRA’s to the Roth IRA. What amount will be added to his taxable income in 2011 and 2012?
First, we take the total after-tax contributions of non-Roth IRA balances divided by the total non-Roth IRA balance. In this scenario, that gives us $20,000/$140,000 to equal $14.29%. Since Steven is only wanting to convert half of his balance, we take that amount $70,000 times 14.29% to equal $10,003. We then subtract that amount from the amount to be converted which equals $59,997 that Steven will owe income tax on.
As you can see, the Roth IRA conversion process can get complicated. Please consult your tax advisor before implementing this strategy.