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

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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.

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DDFD
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DDFD

Nice post.

Roth IRA’s are still good tools, but conversions sometimes make good sense too.

Erica Douglass
Guest

Thanks. I’ll send this to my accountant. 🙂

The link to phase-out limits is broken.

-Erica

Britt
Guest

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
Guest
Rick

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
Guest
Jay

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,… Read more »

Jon
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Jon

What is the answer to Rick’s question regarding losses on conversion?

Jeff Rose
Guest

@ 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… Read more »

Jay
Guest
Jay

Thanks Jeff for the confirmation and also the link to that other article — good stuff.

Andy
Guest

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
Guest
Mark

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 Bhulipongsanon
Member

@Mark – You can contribute after-tax dollars to Traditional IRA, then convert it over to your Roth IRA.

KJ
Guest
KJ

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… Read more »

Arnold
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Arnold

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
Guest
Joe

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
Guest
Adrienne

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… Read more »

Jeff Rose
Guest

@ 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. @ 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… Read more »

MJR
Guest
MJR

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… Read more »

Junior Boomer
Guest

@ 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… Read more »

MJR
Guest
MJR

@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.

DB
Guest
DB

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!

Junior Boomer
Guest

@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.

Tom
Guest
Tom

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.

Bdp
Guest
Bdp

@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… Read more »

George rosenberg
Guest
George rosenberg

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.

Douglas Wilson
Guest
Douglas Wilson

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… Read more »

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

by Jeff Rose time to read: 4 min
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