Roth IRA Conversions

Converting from a Traditional IRA to a Roth IRA

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If you have been saving for retirement in a traditional IRA, you can convert some or all of your traditional IRA funds into a Roth IRA. Beginning in the year 2010, all restrictions on converting to a Roth IRA have been removed. Prior to 2010, individuals were not allowed to convert to a Roth IRA if their income exceeded 100,000. Is converting to a Roth a good idea? That depends on several factors.

Review of IRA Basics

Here's a brief summary highlighting the different rules for IRAs:
  • Deductible Traditional IRAs: tax deduction for the savings contribution; both earnings and initial investment are taxed when withdrawn.
  • Nondeductible Traditional IRAs: partial or no deduction for the savings contribution; earnings tax-deferred until withdrawn; the portion representing your nondeductible basis is returned tax-free.
  • Roth IRAs: no deduction for the savings contribution, earnings are tax-free as long as the funds have been invested at least five years.
With Roth IRAs, an individual basically agrees to pay any tax now in exchange for tax-free treatment when the funds are withdrawn later. To achieve completely tax-free status, investors using a Roth IRA will need to defer taking any distributions from their Roth IRA until at least age 59.5 years old, the original funds have been invested for at least five years, or some other exception applies. Absent any exceptional circumstances, withdrawing money from a Roth IRA early incurs not only taxes on the earnings but also a ten percent penalty.

Prior to 2010, saving money in a Roth was limited to taxpayers who had less than $100,000 in adjusted gross income.

Additionally, individuals who chose to file as married filing separately were completely prohibited from contributing to a Roth, regardless of their actual income. Such individuals had three alternatives for their savings: use a regular savings or investment account, fund a deductible IRA (if they were eligible), or fund a nondeductible traditional IRA.

As we shall see, the benefits of converting to a Roth vary significantly depending on what type of investment vehicle (or "wrapper") was chosen in previous years.

Converting to a Roth

"Converting to a Roth" means, essentially, changing the tax treatment in which your retirement savings are placed. Instead of a tax-deferral available with a Traditional IRA, Roth IRAs represent post-tax contributions. Converting to a Roth means undoing the deferral by paying tax on the accumulated earnings and on any savings contributions for which the person took a deduction. This converts the funds into post-tax money.

Individuals are allowed to convert their savings from a deductible traditional IRA or from a nondeductible traditional IRA into a Roth IRA. (Both deductible and nondeductible IRAs fall under the umbrella of "traditional" IRAs. The term "traditional IRA" can mean either deductible or nondeductible IRA funds.) Beginning with the year 2010, there is no restriction (based on income or filing status) against converting to a Roth IRA.

Converting to a Roth IRA is pretty simple. All you need to do is tell your bank or other financial institution to convert some or all of your traditional IRA funds to a Roth. That's the easy part. You can keep your funds at the same financial institution. You can even keep them invested in the same investments. All you're doing is changing the type of account.

The tricky part is figuring out (1) what the tax cost of converting to a Roth will be, (2) whether converting to a Roth will save or cost you money over the long-run, (3) whether it makes sense to take advantage of the government's one-time only offer to spread the cost of a Roth conversion over two years, and (4) how much to convert. I want to make one point clear: you do not have to convert all of your traditional IRAs to a Roth. You can convert none, some, or all of your traditional IRA savings (whether deductible or nondeductible) to a Roth.

Step one: Calculating "Income" to Report on a Roth Conversion

When a person converts their traditional IRA to a Roth IRA, two things happen. First, the government wants to tax the current value of the funds you convert. Secondly, those funds now become your basis in a Roth IRA. Calculating the tax impact involves three steps.

1. Figure out Your Roth Conversion Income Roth conversion income is equal to the value of the traditional IRA funds on the day you convert, minus any cost basis you have in nondeductible IRAs.

For deductible IRA funds, you will report as income the current value of the funds on the day you convert to a Roth IRA. Your basis in a deductible IRA is zero, since you received a tax deduction for your savings contribution.

For nondeductible IRA funds, you will report as income the current value of the funds on the day you convert less your basis in the funds. For example, you contributed $5,000 in 2008 to a traditional IRA and received no deduction whatsoever for that contribution. Your basis in those funds is now $5,000 ($5,000 of income minus zero deduction). You then decide to convert your traditional IRA in 2010 to a Roth and the value of the IRA is now $5,500. You'll report $500 of income on your tax return ($5,500 current value minus $5,000 in basis).

In many cases, a individual will own both deductible and nondeductible IRAs. In this scenario, the tax laws mandate that your basis (in the nondeductible funds) be spread out over all traditional IRA funds (even if they are held in separate accounts at different financial institutions).

A taxpayer will logically want to convert nondeductible IRA funds first (since there is less of a tax impact). However, that's not how the tax math works out. For example, let's say you contributed $5,000 to a fully deductible IRA in 2007 (which means your basis is now zero in those funds), and in 2008 you contributed $5,000 to an entirely nondeductible IRA (which means your basis in now $5,000).

In this example, you have $10,000 in traditional IRA contributions with a basis of $5,000. If you were to convert all your traditional IRAs into Roth IRAs and the value of your IRA account was $11,000, then you would report as income $11,000 minus $5,000 (your basis), which would be $6,000 in income. A person with mixed traditional IRAs might think to herself: let's convert only the nondeductible IRA. Basis would still be prorated across all her accounts. Assuming the current value is $5,500 in each IRA fund and the investor converted only $5,500 from the nondeductible account, the math would still be the same: $5,500 (current value) minus $2,500 (basis prorated), resulting in income to report of $3,000. As we shall see, there are some special work strategies designed to preserve the tax-deferred status for mixed traditional IRA funds.

People can "isolate" their nondeductible IRA funds using the following strategy. Taxpayers are allowed to rollover funds from their traditional IRAs to a qualified plan such as a 401(k) or 403(b) plan.

Furthermore, taxpayers can choose to rollover only their deductible traditional IRAs. By performing such a rollover, a taxpayer can move all their deductible IRAs to a 401(k) or similar plan, leaving behind only nondeductible funds in their IRA. Then, taxpayers can rollover their nondeductible funds to a Roth IRA. This preserves the basis in their nondeductible IRAs, resulting in lower income recognized on the Roth conversion. The IRS explains this rule about rolling over only deductible IRA contributions in Publication 590: "A special rule treats a distribution you roll over into an eligible retirement plan as including only otherwise taxable amounts if the amount you either leave in your IRAs or do not roll over is at least equal to your basis."

Be aware that you are allowed to perform only one rollover per year per IRA account. So if you intend to utilize this strategy to isolate nondeductible funds in your IRA, you will can do this in the same year by using the following two-step method:

  • Rollover deductible IRAs to a qualified plan in a trustee-to-trustee direct transfer (which doesn't count toward the one-rollover-per-year limit), then
  • Convert nondeductible IRAs to a Roth IRA via a trustee-to-trustee direct transfer (so as to avoid the mandatory 20% withholding).

Step two: Income does not (necessarily) mean Taxable Income

Income reported on the conversion to a Roth IRA does not always mean the income is taxable. The tax impact of reported income can be reduced through the use of various tax deductions or tax credits. Let's take one example designed to demonstrate how the math works in computing taxable income.

Abel converts an entirely deductible traditional IRA worth $5,500 to a Roth IRA in 2010. Since these funds were entirely deductible, Abel will report $5,500 in additional income on his 2010 tax return. Abel is still entitled to take various deductions or tax credits. Abel could therefore offset his $5,500 of additional income with all available deductions or he could simply pay the tax. For example, Abel could offset the Roth conversion income with $5,500 of charitable deductions or with a $5,500 business loss. I mention this because of the way the math works: Roth conversions create income, but not necessarily taxable income.

Step Three: Calculating the tax on the Roth conversion

Income reported on a Roth conversion increases income. Thus a Roth conversion could increase taxable income and could trigger various phaseouts.

An increase in taxable income is fairly easy to figure out. Take a look at the marginal tax rates for the year in which you are converting. An increase in taxable income will cost you, roughly, your marginal tax rate times the conversion value. Be aware that a Roth conversion could push you into a higher tax bracket.

Analyzing various phaseouts is a bit more complicated to figure out. Higher income could result in more Social Security benefits being subject to tax, or could trigger a phaseout or elimination of various deductions or tax credits, or could result in less of your itemized deductions being utilized, or could increase your alternative minimum tax. Hence the best way to figure out the impact of a Roth conversion on these various items is to run a projection in your tax software to analyze the tax increase resulting from a Roth conversion.

Converting to a Roth IRA makes sense in the following situations, in my opinion:
  • You have funds (outside of a retirment account) to fully pay the tax for converting to a Roth.
  • The value of your traditional IRAs has fallen, and converting now is more affordable.
  • You expect to be in roughly the same tax bracket or in a higher tax bracket in retirement than you are in currently.
  • You can utilize losses or deductions or credits to help offset the tax impact of a Roth conversion.
    Converting to a Roth basically means you are paying tax now in exchange for future tax-free withdrawals from your IRA. Paying tax now only makes sense if you expect to be in roughly the same or higher tax bracket in retirement than you are now. Think about it. If you are in the 25% tax bracket now, and expect to be in the 25% tax bracket in retirement, why should you prepay your taxes? Granted, by converting now, your funds can grow and be withdrawn tax-free. Which means that, potentially, you are paying 25% on a lower dollar amount rather than 25% on a higher dollar amount later. But you also give up the opportunity to spread out your IRA withdrawals over time, which could help minimize any tax impact.

    Converting to a Roth IRA does not make sense, in my opinion, in the following situations:

    • You do not have cash funds sufficient to fully pay the tax of the Roth conversion.
    • You expect to be in a lower tax bracket in retirement than you are in currently.
    • You may need to tap into your IRA funds in the next five years and you are or will be younger than age 59.5 when you need to tap into these funds.
    In general it does not make much sense to pay tax now at a higher tax rate if you reasonably expect to be in a lower tax bracket in retirement. It also does not make sense to pay tax now if you might need to tap into those funds in the next five years, in which case you will essentially be paying tax twice, once on the conversion and again on the withdrawal, plus any penalties that might apply.

    Figuring out how much you can afford to convert involves crunching the numbers on the tax cost of a Roth conversion. In general, I am a fan of spreading out tax costs over multiple years. However I do see the mathematical appeal of converting all IRA funds at once in order to take advantage of the tax-free status of Roth IRAs. Here's some tips to aide you in optimizing how much of a traditional IRA to convert to a Roth IRA.

    Consider any losses or deductions you will be eligible for in the year of the Roth conversion that could help reduce the tax cost of the conversion.

    Consider the cash funds you have to pay the additional tax. If you cannot afford to pay for converting all your traditional IRAs to a Roth, figure out how much you can afford to convert. You can always convert portions of your Roth IRA over multiple years.

    Consider the time horizon for your investments. If you are going to need some of your IRA funds in the next five years, keep those in your traditional IRA. Not only does this preserve the tax-deferred status of your IRA, it can help prevent you from incurring a double tax-hit on the Roth conversion.

    Special Rule for 2010 Roth Conversions: Spreading out Income over Two Years

    When a person converts traditional IRA funds into a Roth IRA, the amount of the Roth conversion is included in income in the year in which the conversion is made.

    For the year 2010 only, Roth conversion income is spread over two years, unless the taxpayer elects (chooses) to include all the Roth conversion income on the 2010 tax return.

    This special rule is worth some discussion. For taxpayers converting to a Roth in 2010, half of the Roth conversion income will be included in the person's 2011 tax return and the remaining half in the person's 2012 tax return.

    This rule has the advantage of spreading out the tax impact of a Roth conversion over two years with a one year deferral before payment to the government is due.

    This could allow a person to save up enough money to fully pay for the Roth conversion. It also allows taxpayers to engage in some sophisticated tax planning to help minimize the impact of a Roth conversion.

    This rule has one significant disadvantage. People might see their tax rates increase starting in the year 2011. This scenario envisions that one of the following future events might unfold.

    • If all the tax cuts that Bush signed into law are allowed to expire, then the tax rates that were in effect prior to 2001 will return. This would mean the end of the ten-percent tax bracket. It would also mean that the top tax rates of 33% and 35% will increase to 36% and 39.6%, respectively. Political commentators are unsure if Congress will allow this to happen.
    • President Obama has signaled that it is his wish that the 10% tax rate be continued, but the top tax rates should be increased from 33% and 35% to 36% and 39.6% for taxpayers who earn more $200,000 (or $250,000 for married couples filing jointly).
      Thus it is possible that by following the default rule for spreading out Roth conversion income over two years, a taxpayer could unwittingly find herself faced with a higher tax cost of converting to a Roth. Taxpayers earning more than $200,000 per year should be especially wary about the potential for tax rate increases.

      Taxpayers can opt-out of the default rule requiring Roth conversion income to be spread out over the years 2011 and 2012. To do so, taxpayers will need to make an election to report all the Roth conversion income in 2010. I urge anyone considering a Roth conversion to run calculations to compare the cost of taking all the Roth conversion income in 2010 versus spreading out that income over 2011 and 2012. On the other hand, if a taxpayer expects to have lower income, significant losses or deductions or credits for 2011 and 2012, it may be cheaper to utilize the default two-year rule.

      One Rollover per Year Rule

      Under the general rules for all IRAs, a taxpayer is allowed one rollover per year per account. This applies to rollovers from one traditional IRA to another, from one Roth IRA to another, or from a traditional IRA to a Roth IRA. Direct trustee-to-trustee transfers from a qualified retirement plan such as a 401(k) or 403(b) account to an IRA do not count toward the one rollover per year rule. Also, be aware that the rollovers are allowed once per twelve-month period and are counted per IRA account. Any additional rollover after the first rollover is treated as a fully taxable distribution, and an early distribution penalty may apply.

      Here's an example of how the IRA rollover rules work from Publication 590:

      "You have two traditional IRAs, IRA-1 and IRA-2. You make a tax-free rollover of a distribution from IRA-1 into a new traditional IRA (IRA-3). You cannot, within 1 year of the distribution from IRA-1, make a tax-free rollover of any distribution from either IRA-1 or IRA-3 into another traditional IRA.

      However, the rollover from IRA-1 into IRA-3 does not prevent you from making a tax-free rollover from IRA-2 into any other traditional IRA. This is because you have not, within the last year, rolled over, tax-free, any distribution from IRA-2 or made a tax-free rollover into IRA-2."

      Reporting the Roth Conversion

      Individuals who convert their traditional IRA to a Roth IRA will receive two tax documents and will report the conversion in two places on their tax return.

      Taxpayers will receive a Form 1099-R from their financial institution reporting the Roth conversion. It will be coded as a rollover to a Roth IRA. Taxpayers will use the information from From 1099-R to report their Roth conversion income on Form 8606, with the taxable portion of the conversion income reported on their Form 1040. Forms 1099-R are generally send out by the end of January of the following year. Additionally, taxpayers will receive Form 5498 from the financial institution that received the Roth IRA funds. This form reports the value of the funds received and the value of the account at the end of the year. Generally this form is for information purposes only and does not need to go anywhere on a tax return. Form 5468 is generally mailed out by May 31.

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