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

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, “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.

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.

51 thoughts on “2010 Roth IRA Conversion Rules, What Is The Big Deal?”

  1. 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…

  2. 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?

  3. 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.

  4. @ 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/

  5. 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

  6. 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.

  7. 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.

  8. 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?

  9. 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

  10. 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?

  11. @ 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!

  12. 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!

  13. @ 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.

  14. @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.

  15. In converting a traditional to a roth in 2010, since the IRS allows the income to be recognized in future years, IF I choose to recognize the tax in the current tax year – due to potential increases in the tax rates – would I be able to source the rollover income to the fourth quarter of 2010, or will I need to source the income to the quarter when converted?

    Thanks!

  16. @DB

    There’s nothing quarterly about it. You just add the converted amount to your income for the current tax year (if you elect to pay your tax all in 2010). FYI, this is not the default option, so you’ll have to elect to pay your all your tax for 2010 instead of having it deferred.

  17. Jeff, i have a Roth IRA with about $70K, a annuity with 30K and a 401k with around $50k. i am considering leaving my job this year and wanted to roll my 50K from the traditional ira into the Roth for the 2010 conversion. When is the deadline ? and do I qualify for the 2011, 2012 tax benefits, paying 50% of the capital gains in those two years.

  18. @junior , DB, & Jeff

    I converted 1/4/10.
    I have made higher quarterly payments to account for the conversion. Less of a hit come 1/15/11 or I am supposed to do that since I know it is income this year.
    I was unclear on the 2 or 3 year spread and whether that spread meant the income was realized in 2010, 11, or 12, so if I spread the tax liability although I can not predict my income (it is generally high) I wanted to just get ahead of the pain and try to knock it off this year and pre-expiration of bush tax cuts and pre-god knows what retroactive tax increase.
    The election to pay the tax in 2010 I assume will be on this years 1040 form?
    Great posts and string – Thanks

  19. SIMPLE IRA is an employer-sponsored plan specially established for small businesses. To be eligible for the plan, a business must have less than 100 employees with each employee earning at least $5,000 in the previous earning year.

  20. There is nothing to consider before converting to a Roth IRA. I thought there were certain things to assess before converting just like everyone else; but after I read The Gospel of Roth by John Bledsoe, it was clear that I should convert. The book completely contradicts what I had been reading off every news site and explains how converting as soon as you can is the best option. Because you don’t have to decide whether you want to keep it as a Roth IRA or convert it back to a regular IRA until October 17th, 2011, converting now is like having a free look at the future. If it proves better to convert, then you already converted. If you should have left it as an IRA to save taxes, then convert it back free of penalty. The Gospel of Roth is easy to read and straight forward, and practically made my decision for me.

  21. Rick, to answer your question about loss on a conversion from non-IRA to Roth, you would include that loss on your income tax return of that year. For example, if you incurred a $5,000 loss on converting your non-IRA to a Roth account (because the market value is less than cost), you would be allowed a capital loss on your taxes for the year.

    But back in May of 2006 President Bush signed a $70 billion tax cut provision that changed the eligibility rules for Roth IRA conversions. Starting in 2010, taxpayers with modified adjusted gross income of more than $100,000 will be allowed to convert a traditional IRA to a Roth IRA. This change applies to all years beyond 2010 – and the income taxes due on the 2010 conversion can be spread over two years. So the 2010 conversion amount may be included as taxable income in 2011 and 2012 – helping to spread out the tax bite. Conversions in subsequent years are included in income during the tax year in which the conversion is completed.

    Source: definerothira.com

    For example, let’s say you started to fund traditional IRAs in 2006 and by 2010 you’ve got $20,000 in your account. Furthermore, let’s say this account consisted of four years of $4,000 non-deductible contributions – a total of $16,000 in non-deductible contributions and $4,000 in account growth.

    In this example, you’d need to pay income taxes on the $4,000 in fund growth when you convert to a Roth IRA. But the good news is you’ll never have to pay income taxes on this account again.

  22. The question for me comes down to taxes now or taxes later, but I am leaning toward the Roth IRA account. Big ramifications from the choice.

  23. There are so many blogs written about Roth IRA conversions in 2010, and that they are taxable and how this can be spread over two years, etc. What I have not seen covered anywhere is: What exactly is taxable?

  24. @Charles

    The amount that is taxable is typically the amount that you actually convert (assuming you have no nondeductible IRAs’).

    For example, if you have an old 401k that has a balance of $25,000 the day that you decide to convert, $25,000 is what you will claim as income and pay tax on (either all for 2010 tax year or split between 2011 and 2012).

    Hope that helps!

  25. Read quite a few articles, still confused about one thing. When you says all IRAs are considered as one to IRS does this only include non-deductible and deductible IRAs and not Rollover IRAs (401k rolled over from a previous company)?

    I have non deductible IRA, Rollover IRA from two companies and 401k in 3 companies (old 401k are left in the respective companies)

    In this case can one convert only non deductible IRA and only pay tax on its gain, and Rollover IRA won’t be in the picture??

    Thanks for your great articles.

  26. Jeff: Thank you for the article and subsequent answers to our questions. I am puzzled by one of the implications.

    Is the 2010 Roth conversion tax choice really an either/or situation?
    1. Pay the tax on all the 2010 conversion “income” on filing for 2010 in 2011.
    or
    2. Pay the tax on half of the 2010 conversion on filing for 2011 in 2012 and the tax on the other half on filing for 2012 in 2013.

    Alternatively, can I make the conversion in 2010 and elect to pay the tax on some of the “income” on filing for 2010 in 2011 and the tax on half of the remainder on filing for 2011 in 2012 and the tax on the other half on filing for 2012 in 2013?

    That’s confusing, so let me illustrate with an example:
    Say I had three deductible IRAs of $100K each. Could I elect to convert one in 2010 and pay the $25K tax in full on filing for 2010 in 2011, and also convert the other two in 2010, but elect to pay the $25K tax on half of the $200K on filing for 2011 in 2012 and the $25K tax on the other half on filing for 2012 in 2013? That would spread the tax over three years instead of either one (2010) or two (2011 and 2012).

    If that’s allowable with three separate IRAs, can I apply the same technique to one IRA? Say I had a $500K all-deductible IRA and wanted to convert $300K. Could I extract $100K to be converted in 2010 and pay the $25K tax in full on filing for 2010 in 2011, while extracting another $200K for a separate 2010 conversion and electing to pay the $25K tax on half of this $200K on filing for 2011 in 2012 and the $25K tax on the other half on filing for 2012 in 2013?

    And finally, how is this better than just converting $100K in each of the next three years (2010, 2011 and 2012) and paying the tax in each year as I convert?

  27. @MikeO

    It is an either/or situation. Period. The IRS looks as all your IRA’s as ONE IRA.

    The only way that you can “kind of” get around it is through a spouse and their IRA’s. Your spouse can choose to do the opposite election as you.

    Otherwise, it’s one way or another – no in between (sounds like a good country song….)

  28. I understand the rules of 2010 on Roth and Roth Conversions. I know taxes can be paid 2011/2012 and understand that my income will be more in retirement than currently. I saw all the reasons to convert and agree but my Question is———Are the earnings (interest or dividends or increase in stock value) on the Roth account also tax free when you remove them at retirement age?? Thanks

  29. I think a lot of people don’t realize the benefits of the Roth IRA in terms of tax free growth. I’ve seen several of my friends invest in retirement funds without using the Roth IRA vehicle simply because they didn’t know it exists.

  30. Jeff,

    I converted part of my traditional ira to a Roth in Feb 2010. The value lost 50%. I indicated the tax liability to be spread in 2011 and 2012. In Jan, 2011, I did a recharacterization.

    I figured not taxes due in 2010. Today I received a 2010 1099-R from my broker. It had the conversion amount from Feb 2010 on line 1. Does this seem right to You?

  31. Hi Jeff,

    I ended up converting $50K to Roth in 2010 (keeping my wife and me within the 25% bracket) and planned to pay the tax in the same year — because I thought the Bush tax cuts would be allowed to expire — so I paid estimated taxes each quarter. Now, it makes more sense to defer the tax to 2011 and 2012. However, I have a tax overpayment for 2010 due to the estimated tax payments. If I convert an additional $25K to Roth in 2011, will the additional tax from that just add to the tax due in 2011 for half of 2010’s $50K conversion? Then could I just leave the overpayment with the Feds and use it to prepay my estimated taxes for 2011?

  32. Hi Jeff,
    2 questions

    I will likely convert to a roth IRA this month (Feb 2011).

    Can I pay the tax on my 2010 tax return?

    If I move from a state without state income tax to a state with income tax will I be required to pay the state income tax on the conversion too (if I convert before I move)?

    Thank You Very Much.
    Rachal

  33. Hi Jeff,
    Thank you for the good articles on ROTH IRA conversations. I read all but did not see my situation, hopefully you will help me. Starting with the 2009 tax year I opened a non-tax deductible IRA and converted it to a Roth IRA because my income was to high to open a Roth directly . I have done the same for 2010 and plan to do the same for 2011. I am concerned that I may not have followed the rules because I have a fully taxable 401K in a separate account with a different brokerage from my new Roth conversations. I have no intention to roll over any portion of the old taxable 401K to a Roth. My 401K is 20 years old and was from an old employer. Thank you very much. Ken

  34. Jeff,

    If I contributed to a traditional IRA after taxes prior to and in 2010 and then converted it to a Roth in 2010. I assume there are no tax consequences correct since the traditional IRA contribution was after tax. Thanks

  35. @rachalb

    No, if you convert this year, it will go towards your 2011 taxes.

    I’m not certain on your second question. I would assume it would be based on whichever state you file your taxes in. I would double check with a tax professional to verify.

    @kenbaker

    As long as the 401k stays a 401k, if will not affect your tax return. If you end up rolling your 401k into an IRA in the same tax year that you convert, then it would be applied and you would have to pay tax on a pro-rata basis.

    @norb

    There shouldn’t be so as long as there are no pre-tax IRA’s that exist in your name.

  36. I have a doozy of a question for you, and would appreciate your opinion. We converted an IRA to a Roth in early 2010. The market went down significantly, and we recharacterized. While the market was still down (about 60 days later), we received bad advice. Namely, that we could convert one more time as long as it was 30 days after the first recharacterization. So, we converted again — for the 2nd time in 2010. Now, as we are figuring out our taxes, we realize that the advice we received was wrong. The mistake was related to the rule that if you are straddling a tax year, you need to wait 30 days to convert again. Anyway, regardless, we have now caught the awful mistake. Can we recharacterize NOW (before April 15) to negate or “undo” the last conversion and avoid the penalties? Of course, the $$ would be back into the IRA without the benefits of the Roth, but at least we wouldn’t incur the massive penalities that would now be incurred…

  37. Can you give some reference on the IRA loss rules? I read in Pub 590 that a T/P could recognize a loss only if they took a distribution of all funds in traditional ira’s. Does conversion of all traditional IRA funds to Roth IRA’s satisfy that requirement? Do funds in 401(k) account have any effect?

  38. If a taxpayer didn’t report their Traditional IRA conversion on their original return and didn’t file an extension, can they make the election to spread the income and tax over 2 years on their amended return or is this option lost because they original filing deadling (April 18) has passed and they didn’t request an extension.

  39. I converted a traditional IRA to a Roth ira in Jan of 2010 and opted to pay the taxes in 2011 and 2012. Can I still recharactarize the account before Oct 15, 2011 and avoid the taxes in 2011 and 2012?

  40. I converted to a roth in 2010 tax year. I am happy with declaring the 1/2 in 2011 business but it is looking like I may want to recharacterize the 2012 1/2. Is that possible?

  41. I am in a real bind. I did a Roth conversion in 2010 on two separate IRA accounts resulting in two different separate ROTH IRAs. I tried to recharacterize one of the ROTHS, but my broker did not process the recharacterization. They say they received it before the deadline, but they did not have time to process it before they left the office for the evening (yes, definitely my mistake, I waited until the last day).

    I am single, but I have to split the taxes of a 2010 ROTH conversion over tax years 2010, 2011, and 2012 by paying taxes on one ROTH conversion for tax year 2010 and for the other tax year 2011 and 2012. (By tax year, I of course mean the year the tax liability is incurred, not the year it is payable.) I know that married couples can do this, but is there any way for a single person to do this?

    Or is there a way to petition the IRS to accept the recharaterization?
    Thank you very much!

  42. I took advantage of the 2010 conversion and split the amount on my taxes, 1/2 in 2011 and 1/2 in 2012.

    I am working on my 2012 taxes now and I have a question.

    I was living in Oklahoma in 2010, 2011, and only 3 months in 2012. On my Oklahoma tax return do I need to put the full amount for 2012 or can I divide the amount by 12 and multiply it by 3 since I only lived in Oklahoma for 3 months?

    Thank you.

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