Roth Conversion Rules

Posted by Jill on March 16, 2010

Today we’re covering the Roth conversion rules in the second of a series on Roth IRA conversions.

As mentioned yesterday in How to Make a Roth IRA Conversion, some special rules went into effect on January 1 that make 2010 Roth IRA conversions more attractive than ever.

Roth Conversion Rules

If you haven’t yet, you should really consider converting to a Roth IRA this year. This is especially true if you do not qualify to contribute to a Roth IRA and have been unable to reap its benefits.

Income Limit for Roth IRA Conversions

No income limits: For the first time ever, all taxpayers can rollover a traditional IRA to a Roth IRA, regardless of income. So if you’ve had too high of an income to contribute to a Roth, and took advantage of a deductible or non-deductible traditional IRA instead, you can convert all contributions plus growth to a Roth – paying taxes on the converted amount but then enjoying tax-free growth forever. As of now, this provision is permanent. Before 2010, your modified AGI for Roth IRA purposes could not be greater than $100,000.

2010 Taxes

Rules specific to 2010 roth conversions include the following:

Extension of tax payment: Ordinarily, taxes are due on all IRA account growth as well as any deductible contributions. In 2010, you can actually defer paying taxes on the converted amount by completing the conversion in 2010 but claiming half the income in 2011 and half in 2012 – meaning half of the actual tax payment could be deferred to spring of 2013! You can also elect to pay all taxes in 2010. Be aware that you will pay taxes at your rates in those years, so you should pay now if you expect your personal bracket to increase. Spouses can make different elections, but each taxpayer has to apply the same election to all accounts – you can’t choose to pay taxes on one IRA but defer them on another. This election is special for 2010 and will expire in 2011.

Pro-rata Tax Treatment Rules Apply

If you do choose to go the conversion route, you don’t have to convert all your funds. One reason to do it in pieces is to spread your tax bill over many years. However, if you have made both deductible and nondeductible IRA contributions, any partial conversion will be deemed to come from both pools, in a ratio equal to your original contributions.

What this means is, you can’t avoid taxes by choosing to convert only nondeductible contributions. However, if you’re willing to put in some work, there is a Roth conversion workaround strategy.

Pro-rata tax treatment of the tax-deferred portion of IRAs. When completing the conversion from a traditional IRA to a Roth IRA, you must include a portion of tax-deferred money in the IRA in proportion to the amount held.

For example, let’s say I have an IRA worth $100,000, with $50,000 (50%) tax deferred and $50,000 after tax. I complete a conversion of $20,000 to a Roth IRA. I will be responsible for taxes on $10,000, or 50%. You cannot specify to convert only the after-tax money in the account, unless you take advantage of roth conversion strategies like increasing your basis.

Other Roth Conversion Rules

Other than the two mentioned above, Roth conversion rules remain the same. So remember:

  • Contribution limits remain the same. 2010 Roth IRA limits haven’t changed. If you are over the income limits for Roth IRA contributions, you cannot contribute new funds to a Roth. However, as long as the special 2010 roth conversion rule above exists, you can contribute to a traditional IRA and immediately convert.
  • Regardless of the timing, taxes will be due. At some point, you will owe taxes on your Roth conversion, whether you choose to defer them or not. You should only convert if you can afford to shoulder the tax bill with non-retirement funds. If you use part of the converted amount to pay taxes, you miss out on the compounding growth and may face an early withdrawal penalty.

Other considerations

There are additional rules to consider when converting. You must complete the conversion within 60 days. You cannot be married and file a separate return. Finally, when evaluating your IRA all accounts are considered one, regardless of what custodian holds the funds.

Check back tomorrow to find out Should You Do a Roth Conversion?





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Comments to Roth Conversion Rules

  1. Hi,

    I need your guidance in Roth conversion for 2010. Here is my situation:
    – I’ll be non resident by jun-2010. Going out of US for 7 yrs (may be more) assignment with family.

    -I don’t have Roth IRA for now but have 401K from employer.

    In this situation How can I save money on my Roth Conversion? From next year I don’t have any income here in US so Can I withdraw from my IRA upto my standard deduction amount and put into Roth IRA to avoid penalty?

    What would be good strategy to lower my tax bill for 2010 and 2011 or infect coming years as well as avoid penalty on early withdrawal from 401K?

    Thanks for your help,

    Lee

    Lee

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