If you have considered converting funds to a Roth (the IRA, not David Lee) from a traditional IRA or a qualified (tax-deferred) plan like a 401(k), undoubtedly you have run across this tax code item: in 2010, the income limit for Roth conversions is lifted. On top of that, the IRS will give you two years to pay the tax on your conversion, with the tax for a conversion in 2010 evenly split, coming due in 2011 and 2012. You don’t have to split the tax, you could pay it all in 2010 if you like, which might be useful if it would be more expensive to delay the tax.
So – why is this a big deal? Well, in the past, there has been an income limit of $100,000; meaning that you could not convert traditional IRA funds to a Roth IRA if your MAGI was above that level.
So, back during the bad old Bush days (Remember when? That was before hope and change…), when the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) was passed in 2001, this particular provision was put into place. And so, some folks have been looking forward to 2010 ever since (in spite of all of the other tax provisions that are expiring in 2010).
Six Factors to Consider Before Converting to a Roth IRA
If this provision impacts you, it makes good sense to begin planning now for the potential of converting your IRA to a Roth next year. Here are six factors to consider:
- If you convert funds from an IRA to a Roth IRA, it is most advantageous if you are able to pay the tax on the conversion from funds outside of your IRAs. If you can’t do this, realize that any funds used to pay tax on the conversion will also be subject to the 10% early withdrawal penalty if no other exception applies and you’re under age 59½.
- What is your outlook on tax rates? A Roth conversion, especially when there is a sizeable amount to convert, may be taxed at some very high rates, depending upon your situation. For example, a couple who would normally have a MAGI of $110,000 would have a marginal 25% rate. Add in a $200,000 Roth IRA conversion, and a portion of those funds would be taxed at as high as the 33% rate. It only makes sense to convert if you believe the rates in the future would be higher than the rate you’d pay tax on the conversion today.
- Does your IRA contain nondeductible contributions? If, in years past, you have contributed nondeductible amounts to your IRA due to income limits, the Roth conversion of those amounts is a no-brainer for you. However, you must be careful about how you do a conversion in this case, because any amount that doesn’t represent your nondeductible contributions would be considered taxable upon the conversion. (see Note below for additional explanation)
- When do you plan to access your funds? If it’s going to be several years (10 or more) then you will have a better chance of having recouped the tax outlay by way of the tax-free growth in the account.
- If you need to access the funds from this account much sooner, bear in mind that funds converted to a Roth IRA can’t be distributed for five years after the conversion. This could throw a wrench in the entire process if you needed access sooner.
- If you don’t plan to ever access these funds, a conversion may may sense for you, since a Roth IRA has no Required Minimum Distribution. This way, you won’t have to deplete your IRA balance (after age 70½), and your heirs will reap the benefits of a much larger account, all tax free.
Note: A complication comes up when you have a combination non-deductible contributions and otherwise taxable growth or deductible contributions housed in the same account: IRA rules require that distributions (including conversions) must be taken out ratably, or in the proportions of the entire account.
For example, if you had an IRA with a $100,000 balance, of which $50,000 was non-deductible contributions, $30,000 was deductible contributions, and $20,000 was growth, then for every dollar that is distributed by conversion, fifty cents would be taxed and fifty cents would be tax-free return of your basis.
One way around this is to rollover the amounts above and beyond your nondeductible contributions into a 401(k), or other eligible plan (but not an IRA), and then convert the remaining amount (the nondeductible contributions) to your Roth IRA. This would effectively be a tax-free maneuver. Consult your tax advisor to make sure you’re doing this correctly.
I can learn from you, you can learn from me - please leave your comments and links!Jim Blankenship, CFP®, EA, is an expert in personal retirement, IRAs, and tax issues, with more than 20 years of experience in the industry. . Read more from this author
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Federal income tax on the earnings on the non-deductible would have to be paid is this correct?
All of our funds are in CD’s. We have $18,000 each that was non-deductible.
We each have a CD for a little over $100,000 that is due the end of Dec. We could each put $18,000 in an IRA Money Market or IRA savings and the rest back into a CD and then in Jan when we are able to convert because of the law changes, we could each convert that $18,000 in to a Roth with no tax consequences. Is this correct? We have done our 8606′s thru 1995
Please email any information to rosie43@triton.net
Good article – addresses a lot of the questions about whether or not to convert. For more information check out this web site…www.2010RothConversion.com
Hi, Rosie – yes, that’s correct, unless you move the growth or earnings out of that account prior to the conversion, any earnings on your nondeducted contributions would be taxable upon conversion. The earnings would have to be in a separate account altogether, not just in a different holding (such as a separate CD), as your conversion from any specific IRA is done ratably, as described above.
Hope that helps!
Another words if I have $100,000 CD that is due in Jan and I have a basis or non-deductible amount of $18,000, when this CD is due I can put the $18,000 in an IRA savings account and the rest into another traditional IRA CD, and then a few days later convert this $18,000 in the IRA savings to a Roth CD with no tax consequences.
As long as you move everything but the $18,000 to another qualified retirement account (other than an IRA) – this is critical. From your wording, it’s not clear that this is what you have in mind.
The reason it can be confusing is because in one IRA account you can hold many different investments – CD’s, mutual funds, money market, bonds, stocks. You need to make sure that you’re moving everything but the nondeductible contributions into another qualified retirement account (other than an IRA) – and it has to go that way, you shouldn’t move the non-deductible contributions to a separate IRA, as then you’d need to wait 12 months before you could do the conversion (you can rollover IRA funds once per 12 months).
Does that clear things up? If not, let me know – we may need to get on the phone to talk it through.
I just called IRS badge number 0247025 and she said all IRA CD’s would have to be closed to do this, not just one that has over $18,000 in it.
Let’s talk about this on the phone – I will be back in my office at approximately 3pm central time, you can call me at 866-374-4203 if you’d like. There must be something about your situation that is unusual, otherwise the IRS person is just completely wrong, because you can do this – unless, as I say, something is unusual about your situation.
Okay – I’ve found the answer: the account that you move everything but the nondeductible contributions into can be any account but another IRA. So the amount could be moved into an employer’s 401(k) or other qualified plan.
My apologies for the confusion, and I hope this clears things up. I have adjusted the information presented in the article to reflect the corrected recommendations.
That is what she told me. I needed another qualified plan. I am not working so I no longer have a 401K. We are 100% in CD’s so I cannot do this. Thank you for your help. I love learning new things. Just wished I could have taken advantage of this. A lot of our CD’s are still earning over 6 1/2%. I cannot cash them in early. Guess I will have to use that horrible formula. An interesting discussion.
Yes, good discussion, and I’m glad that you caught that, I’d hate to have misleading info out here.
Sorry it doesn’t work out for you – any chance you could pick up a part-time job with a 401(k), or self-employment where you could set up a solo-K?
As many times as I have thought about post-tax IRA’s, I have never thought of David Lee. Thanks for making me laugh out loud.
Glad I could give you a laugh! Have you found any other celebrities hidden throughout the blog?