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LeAnn Luna
LeAnn Luna
Roth IRA Conversion Tricks and Traps

Beginning in 2010, investors can convert an existing IRA into a Roth without regard to income. Here’s how.

December 10, 2009
by LeAnn Luna

Roth IRAs offer a number of advantages to their traditional individual retirement account (IRA) counterpart. Perhaps most significantly, contributions are not deductible, but distributions are tax free, both for the taxpayer and his or her heirs. A Roth IRA is not subject to required minimum distributions (RMD) for retirees, although RMD rules do apply to non-spouse beneficiaries. Unlike contributions to traditional IRAs, Roth IRA contributions can be made at any age. Until now, Roth IRA conversions were not available to individuals with incomes exceeding certain thresholds, but changes in the tax law effective January 1, 2010 allow taxpayers to convert existing retirement accounts to a Roth IRA without regard to income or filing status. This article discusses how the new rules expand access to Roth IRAs for clients at all income levels and discusses factors to keep in mind in common planning situations.

Elimination of the Income Limit on Conversions to Roth IRA

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Prior to 2010, individuals with existing retirement accounts including IRAs could convert those accounts to a Roth only if their modified adjusted gross income (AGI) in the year of conversion was $100,000 or less. However, beginning January 1, 2010, those AGI limits permanently disappear and any individual who meets the other requirements for converting an existing plan to a Roth can do so without regard to his or her income. Furthermore, for those individuals with existing IRAs or other convertible retirement accounts, 2010 provides some appealing options for paying the taxes due on the Roth conversion. For conversions in 2010, individuals can either pay the entire tax on their 2010 tax return (payable in 2011) or report half of the conversion income on their 2011 tax return and half in 2012.

Tip: Taxpayers who expect tax rates to increase pay for current healthcare proposals or otherwise address large federal deficits might prefer to pay tax in 2010 rather than defer income into a potentially higher rate year. Luckily, for conversions during 2010, taxpayers can make the election as late as October 15, 2011 for a properly extended return. Note, however, value-added tax (VAT) and national retail sales tax are potential new taxes that could decrease future individual income tax rates.

Who Should Convert?

While an in depth analysis of who should consider converting is beyond the scope of this article, a couple of points should be made. If a taxpayer expects his/her marginal rate to be higher at retirement than in the conversion year(s), he or she should consider converting all or part of an existing plan to a Roth. The best scenario, of course, is a zero tax rate in the conversion year. Net operating losses created during the recession could create a window to accomplish a conversion to a Roth IRA tax free. Taxpayers whose income dropped for any reason (temporary job loss, large charitable contributions, returning to school) could find the temporarily low marginal rates provide an opportunity to convert at a lower rate.

Tip: Since the income limits are repealed “permanently” taxpayers should consider converting existing deductible IRA balances over several years to avoid the income from Roth conversions pushing taxable income into the highest brackets.

When Should Taxpayers Convert?

The timing of the Roth conversion can have a big impact on the tax owed. If an existing IRA increases in value while the taxpayer is waiting to convert, the taxpayer will need more outside funds to pay the conversion tax than if conversion to the Roth occurred sooner. On the other hand, converting just before a sharp downturn in the markets is also problematic — the taxpayer will effectively owe tax on investment losses. However, if the value of the Roth IRA declines, investors have until October 15th of the year following the year of conversion to undo the transaction. For example, if taxpayers convert their IRA to a Roth IRA on January 5, 2010, they will have until October 15, 2011 to effectively undo that transaction. If desired, taxpayers can reconvert to a Roth as early as January, 2012. This downside protection effectively means the best advice for many taxpayers is to convert as early as possible.

Tip: Comingling existing Roth balances with newly converted funds complicates re-characterizing conversions after a market downturn. Taxpayers can facilitate the process by using a new Roth account to hold converted funds. An even better strategy might be to create separate accounts for each major Roth IRA asset class. For example assume that a newly converted Roth is invested in commodities and equities. During 2010 the equities portion declines in value but the commodities increase in value. If the taxpayer held the asset classes in separate Roth accounts, the taxpayer can re-characterize only the Roth account that is invested in equities. This strategy is not available if the asset classes had been comingled in one account.

Non-deductible Contributions

Joint filers with modified AGI in excess of $176,000 (in 2009) are not permitted to make contributions to Roth IRAs. But the ability to convert non-deductible IRAs to a Roth IRA without regard to income makes the Roth contribution limitations effectively moot for some taxpayers. An investor can first make a non-deductible contribution to a traditional IRA without regard to income and then immediately roll that balance into a Roth IRA. If a taxpayer has no existing IRA balances, this technique works well.

Trap: Assume a taxpayer has an existing IRA funded with deductible contributions with a current balance of $100,000. If a high income taxpayer makes a $5,000 non-deductible contribution for 2009 in anticipation of rolling that amount into a Roth, he or she could be in for a surprise. The taxpayer cannot specifically convert just the non-deductible contribution. Even if the taxpayer creates a new account to accept the non-deductible contribution, all IRAs are combined to determine the taxable amount of a distribution. The excludible amount is the ratio of total non-deductible contributions divided by the balance of all the taxpayer’s IRAs. In this case, the exclusion ratio is equal to $5,000/$105,000 and 95.2 percent of the rollover will be subject to income tax.

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LeAnn Luna is an associate professor of accounting and holds a dual appointment with the Department of Accounting and Information Management and the Center for Business and Economic Research, both at The University of Tennessee.