2010 Roth IRA Conversion Rules, What Is The Big Deal?

By Jeff Rose, on September 14, 2009

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.

Roth IRA Is Tax Free Money

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, “WhyI 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.

The 2010 Roth IRA Conversion Event

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.

Tax Ramifications of Converting To A Roth IRA

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.

Spread Your Tax Burden Across 3 Years!

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.

Timing On The Roth IRA Conversion

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.

Backdoor On New Contributions

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.

Roth IRA Conversion Tax Calculation Example

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
SIMPLE IRA	$40,000	N/A	$15,000
Traditional IRA	$100,000	$20,000	N/A
Roth IRA	$20,000	N/A	$10,000

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.

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Jeff Rose is an Illinois Certified Financial Planner(TM) and co-founder of Alliance Investment Planning Group. He is also the author of Good Financial Cents, a financial planning and investment blog. You can also learn more about Jeff at his website Jeff Rose Financial.

All posts by Jeff Rose

20 Comments

DDFD @ DivorcedDadFrugalDad
September 15, 2009, 9:34

Nice post.

Roth IRA’s are still good tools, but conversions sometimes make good sense too.
Erica Douglass
September 15, 2009, 12:04

Thanks. I’ll send this to my accountant.

The link to phase-out limits is broken.

-Erica
Pinyo
September 15, 2009, 12:13

Thank you. I’ll be forwarding this to my accountant as soon as I find one too.

PS: I fixed the broken link.
Britt
September 17, 2009, 16:33

The biggest deal is the backdoor method for making new contributions. It effectively eliminates the Roth IRA income limits. Why is it such a big deal? Because it goes on indefinitely (until the law is changed), whereas the 2010 tax deferral is a one-time deal…
Rick
October 8, 2009, 13:06

What are the tax effects of converting a non-deductible IRA to a Roth, where the value of the non-deductible IRA is less than your cost? Do you get to deduct the loss somewhere?
Jay
January 4, 2010, 1:04

Hi Jeff,

Thanks for this article and especially the example — it helps a lot. With regard to the “Backdoor on New Contributions”, I think that only works if you haven’t previously contributed pre-tax money to any of your unconverted non-Roth IRAs, AND those unconverted non-Roth IRAs haven’t grown much in value. Otherwise you wind up paying taxes on the new contributions that you are trying to immediately convert over to Roth.

For example if I imagine a “New Traditional IRA” account to add in to your example, with a value of $5,000 from a recent after-tax contribution of $5,000, then the relevant fraction becomes $25,000/$145,000 and if we just want to convert that recent $5,000 contribution we wind up paying taxes on $4,138 or over 80% of it. Ouch.

Now, if we were starting fresh, with no previous balances, then it would all work out — the ratio would be $5,000/$5,000 and we’d owe no taxes on the immediate conversion. This would also be the case if we had previously converted all the existing balances. In either of these scenarios we could go forward every year with this immediate conversion approach, effectively bypassing the phaseout limits with no tax hit.

This whole topic is certainly not as simple as it might appear! Thanks again.
Jon
January 5, 2010, 12:38

What is the answer to Rick’s question regarding losses on conversion?
Jeff Rose
January 5, 2010, 13:14

@ Rick and Jon

You will only be able to take a loss if it’s the only IRA you have and/or you close out all your IRA’s to get the loss. Also, it’s not a straight capital loss. You are limited to a miscellaneous itemized deductions on Schedule A of your Form 1040 which are limited to 2% of adjusted gross income.

@ Jay

You are absolutely right and that’s what I tried to illustrate in the last example. You have to be careful on converting “New IRA’s” or non-deductible IRA’s because the IRS will look at all your IRA’s together. Here’s another article I did on the topic that might help:

http://www.goodfinancialcents......tax-rules/
Jay
January 6, 2010, 1:09

Thanks Jeff for the confirmation and also the link to that other article — good stuff.
Andy
January 14, 2010, 16:44

The new Roth IRA Conversion rule is a great one to take advantage of this year. With taxes in the long term going only one way (up!) converting now can make a lot of sense for those with higher incomes
Mark
January 15, 2010, 13:21

If I convert our traditional IRA to a Roth IRA, can I continue to contibute to that new Roth account? Our income is over $177,000. Not sure we can from what I have read.
Pinyo
January 16, 2010, 11:04

@Mark – You can contribute after-tax dollars to Traditional IRA, then convert it over to your Roth IRA.
KJ
February 4, 2010, 12:55

We converted my 401K rollover IRA into a Roth IRA this past year. Our combinge MAGI for 2009 ended up being over the $100,000 limit (something we didn’t expect at the time of conversion). If we pay the penalty on our 2009 taxes since the conversion was done in 2009, will we continue to be penalized in the future even though in 2010 the limit is being removed? We would recharacterize it back to a rollover, but it was put into a Roth account I already had, so the earnings/loss calculation would result in a much larger amount of money being recharacterized than what was originally converted. So if we only have to pay the penalty this one year, it’d be worth it to not recharacterize.
Arnold
February 24, 2010, 14:01

Hi Jeff,
I’m confused about the section “Spread your tax burden across 3 years” What 3 years? Does this imply that the income from the conversion can be attributed 50% to 2011 and 50% to 2012; which will then be “paid” when filing in 2012 and 2013?
Joe
March 1, 2010, 17:56

Hi Jeff,

I have a Traditional IRA worth about $75K. I’m considering converting it to a Roth to create a taxable event that I could apply “business losses” against that I accumulated after unsuccessfully operating a business to 2 years and closed June 2009.

Does this make sense to you?

Thanks Jeff
Adrienne
March 2, 2010, 21:29

I will be converting my credit union IRA to a ROTH, and understand that I will need to take a distribution in 2010 for the “over 70-1/2″ requirement. I’ve been told by credit personnel that the distribution must be done and paid from that IRA in conjunction with the ROTH conversion. I have another IRA with my investment banker and have been taking an annual distribution from the combined amount owed from there and the credit union. Can I still do that in 2010, or must I physically remove the money out of the credit union IRA before being qualified for the conversion to a ROTH?
Jeff Rose
March 3, 2010, 23:42

@ Arnold.

That is correct. The default option is to postpone any tax being paid for the 2010 tax year and the remainder to be divided between 2011 and 2012.

@ Joe

It sure does. I personally haven’t advised any clients to do this, but I have read case studies where business owners are applying their NOL to take advantage of the conversion. Here’s an article I found that might answer your question: http://rothiraaccountrules.com.....ss-owners/

@ Adrienne

I had a hard time following your question so let me explain it like this. While you have an IRA held at two different financial institutions, according to the IRS you have “one” IRA. Your RMD is based on the total of all your IRA’s and doesn’t matter what IRA it comes from. (All from one, 60% from one, 40% from another, etc.) To do the conversion, you first have to take out the RMD amount and are able to convert whatever amount you want after that. Hope that helps!
MJR
March 15, 2010, 3:00

Jeff,

As you’ve pointed out, if one does a Roth conversion in 2010 (taken as income for 2010) and decides to recharacterize, the deadline for recharacterization is April 15, 2011 + 6 months = October 15, 2011. The mechanism of recharacterization involves obtaining a 6-month filing extension on April 15, 2011 for one’s 2010 taxes or doing an amended return within 6 months. So the October 15, 2011 date is not arbitrary in its origin.

But as your blog explains, in 2010 one can elect to pay taxes on a 2010 conversion as income for 2011 and 2012. By analogy to the 2010 approach, one might assume that the deadline for reconversion would be October 15th of 2012, i. e., the due date of the first tax payment plus 6 months extension. [Or even October 15th 2013, depending on the way that the recharacterization is handled in the context of the 2011-2012 taxable income alternative.] What’s your understanding of this?

Thanks!
Junior Boomer
March 15, 2010, 14:51

@ MJR

Even though you are allowed to defer the tax for the 2010 tax year and split the tax in 2011 and 2012, the recharacterization deadline for 2010 is still October 15, 2011.

You have to assume that IRS is still giving you more than 3/4’s of a year to see if the conversion was in your favor or not. There may be a case where someone elected to defer the tax until ‘11 and ‘12, speculating they would be in a lower tax bracket later on only to find out a promotion is imminent. That individual then may want to recharacerize and elect to pay the entire tax in 2010 instead.

These situations are case by case, but a definite reality.
MJR
March 15, 2010, 21:09

@Junior Boomer

Thanks for your reply. I have to agree that October 2011 is a pretty generous recharacterization point for a conversion in 2010. I will be doing multiple conversions with different investments and keeping only the ones that turn out well – hence my interest in the latest possible recharacterization date.

One more question (for anyone who knows): Will most states (I’m in California) mimic the federal tax treatment of income taken in 2011 and 2012 from a 2010 conversion?

Thanks again.

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