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The rules of converting to a Roth IRA may be complicated, but staying on top of the latest changes could boost your nest egg, says Money Magazine’s Walter Updegrave. NEW YORK (Money) — Question: It’s my understanding that starting in 2010 the rule that prohibits you from converting from a traditional IRA to a Roth IRA (for modified adjusted gross incomes over $100,000) will be eliminated. If that’s the case, can I convert all types of IRAs - deductible IRAs, nondeductible and even rollover IRAs that contain money moved from a 401(k) plan? How long do I have to do this? Do the new conversion rules expire at some point? –Hussam, Bergenfield, New Jersey Answer: A gold star to you for keeping on top of changes to the Roth conversion rules! As part of the Tax Increase Prevention and Reconciliation Act that became law in May of 2006, Congress eliminated the restriction you mentioned for converting to a Roth IRA, (although until 2010 the current income eligibility rules still apply). And other than an IRA inherited from someone besides your spouse, any type of IRA can be converted to a Roth, whether it’s a traditional deductible, nondeductible, a rollover IRA or, for that matter, even a SEP or SIMPLE IRA (although unless you’re 59 1/2 or older, you must have had your SIMPLE IRA more than two years). As I noted in Money Magazine shortly after this provision passed, doing a Roth can be a pretty sweet deal. So as far as I’m concerned, anything that makes the conversion option available to more people is, as Martha might say, a good thing. Soften the tax blow
In fact, this legislation also offers two other goodies. First, if you convert in 2010, the income you must pay tax on will be split equally between 2011 and 2012, which defers the tax hit. If you think you’ll be in a lower tax bracket in 2010 than later on, however, you can elect to recognize the income that year. Get in through the back door
Second, while Congress kept the rule that prevents you from making annual contributions to a Roth if your income exceeds certain thresholds, the new Roth conversion rules give you an easy way around this restriction starting in 2010. Just contribute to a nondeductible IRA - which anyone with earned income can do - and then convert to a Roth. You can even get a head start on this end-run by contributing to a nondeductible IRA before 2010 and then converting when the new rules go into effect that year. Beware of blended IRAs
If you do decide to convert - whenever that may be - you should be aware of one aspect of the rules that can trip you up if you’ve contributed to a nondeductible IRA or rolled an after-tax 401(k) into an IRA rollover. Here’s an example. Let’s say you have two IRAs with a total value of $50,000. One is a traditional IRA that has a $25,000 balance consisting of both deductible contributions and earnings on those contributions. The other is a nondeductible IRA that includes $20,000 of nondeductible, or after-tax, contributions and $5,000 of earnings. If you decide to convert all your IRA money, then $20,000 (the amount you contributed on a nondeductible, or after-tax, basis) would not be taxable since you’ve already paid the tax on that money. But the remaining $30,000 (your deductible contributions plus the investment gains in both accounts) would be taxable since Uncle Sam has yet to get his share of that money. But suppose you wanted to convert only a portion of your IRA funds, say, half of your $50,000. In that case, you might say to yourself, gee, I’ll leave the deductible IRA with its $30,000 of taxable money alone and convert the nondeductible IRA, so I’ll owe tax only on the $5,000 of investment earnings in the nondeductible IRA account. Alas, you can’t cherry pick IRA funds this way. Instead, when doing a conversion you must consider all of your non-Roth IRAs - deductible, nondeductible, rollovers, even SEP and SIMPLE IRAs - as one big pie that can contain both taxable and nontaxable money. In the scenario above, your already-taxed nondeductible contributions of $20,000 account for 40% of your total, while the $30,000 of yet-to-be-taxed deductible contributions and investment earnings represent 60% of your $50,000 IRA pie. Whether you convert the entire $50,000 or just a slice of it, 60% is considered taxable income. So if you choose to convert a $25,000 slice of your $50,000 IRA pie, then $15,000 (60% of $25,000) is taxable. It doesn’t matter where you carve the slice from. Each slice of the pie has the same mix of taxable and nontaxable money as the whole. If you’ve made nondeductible, or after-tax, contributions to an IRA, IRS form 8606 will take you through the gory details of calculating the taxable vs. nontaxable portion of your conversion, although you’ll also have to plow through the instruction booklet to make sense of the form. Bide your time
As for whether there’s a time limit to new conversion rules, well, Congress didn’t include any expiration date. And since looser restrictions are likely to lead to more Roth conversions and, hence, more tax dollars in the near term for the boys and girls down in DC to play with, it would seem unlikely that our legislators would turn off the revenue spigot anytime soon by tightening the restrictions again. But I don’t consider any tax rules permanent. Given Congress’s predilection for re-writing the tax code, I’d say the word permanent doesn’t apply to taxes at all (except in the sense that taxes of some type will probably always be with us). So while you certainly don’t want to rush into a conversion - in fact, it’s a good idea to check out a calculator to see if it makes sense for you - I don’t see a reason to dawdle if you think a conversion is appropriate. It would be a shame to miss out if Congress changes its mind again.
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Posted by kpantelides 9:18 am 15 Comments
 | Add a comment I have been watching my Roth IRA account and the value of my account is going down every day. I am in for longterm investment, so I am not worry about this because I know it will bounce back and I am not close to retirement. My delimma is, I have some money to invest into my Roth IRA and not sure if I should invest now or I should wait out a little longer for the fund price to get lower. I would appreciate any advice. Posted By Joy, Charlotte, NC : March 7, 2008 4:44 pm
It seems to me that the IRA idea (not Roth) is a way of timing for the government - i.e. When people are withdrawing and paying taxes on previously deductible IRAs and 401(k)s they will also be receiving social security and medicare. So the Gov has some tax dollars coming in to help at that time. Of course the Roth does not apply. I think it may be good to try and have a bit of both tax free and taxable income. Posted By Jeff, Fairfax, VA : February 29, 2008 6:18 pm
Mike - so you’re telling me that you would convert you trad. IRA EVERY year to a Roth for the potential tax savings. Also, if you converted the max. amount contributed (2008-$5k) from your trad. IRA, you would need $1250 to pay the tax bill on this rollover (25% tax bracket), (provided you did it immediately and there was no growth. EVERY. YEAR. What a headache! Granted if you’re young this may work out better for you in the long run, but I’d rather live life, my friend. I’ll think of you once a year when you’re completing the paperwork for your annual rollover…. when I’m out playing golf. Posted By CFP(R), Chicago, IL : February 27, 2008 3:14 pm
Since the US debt is now about 75 trillion (including unfunded future liabilities), we’re all screwed. Expect your taxes to jump back to 80-90% in the highest bracket (remember the Eisenhower era?). Too many hands out. What to do: Give citizenship to only those who can bring in massive assets or income (and make them keep it here like Canada), or the young (who have the potential to pay SS and medicare taxes). Ship out the illegals not paying taxes. Increase smoking and behaviors to get people to die closer to 65 (sorry but it pays off). Make fat people pay more in health care (they use more). Reduce the Military and work on defense only, not offense. Posted By Jay wilson Phoenix AZ : February 21, 2008 1:11 am
OK, let me get this straight. Ever since I heard about this Roth back-door i’ve been contributing to a Non-deductable IRA with the idea of converting in 2010 when the income restrictions are lifted. If I understand the article correctly, I can’t isolate this non-deductable IRA for this converssion, but must include my other IRAs as well? Posted By Jim Bedford NH : February 20, 2008 4:59 pm
Government and business has many of us in a bind. Lack of retirement plan at work, limits on Roth, IRA and 401K eligibility for upper middle income - money that could go to 401K or IRA, goes to taxes instead when the company 401K in retail business has maximum contribution,even older than 55, of $3900 due to number of 20-30 year old employees who do not contribute to 401K. Posted By Paul, Turnersville, NJ : February 20, 2008 4:48 pm
CFP(R)…Ihope you are not a “CFP.” Very simply, as the article clearly says, you contribute to a traditional and immediately convert to your Roth in future years. So, yes, you can continue to contribute every year by going through this back door method. go back to the tax section of the CFP exam, my friend. Posted By mike, syracuse, ny : February 19, 2008 8:37 am
I expect the government will use the Roth IRA in someway to offset what you receive from Social Security. Remember contributions to Social Security are like Roth IRA contributions; ALL of the contribution was taxed prior to contribution! As self employed, I paid both half of Social Security and now 85% of what I receive is taxable. Posted By Charles Wilklins; Fremont, CA 94536 : February 18, 2008 7:51 pm
I think your are quite right to not consider any tax rule permanent. If the IRA conversion is a good deal for the populus, at some time in the future the government will be faced with diminishing taxes from conventional IRAs and a whole lot of untaxable assets in the Roth IRAs. I fully expect the government to change the rules at that time. Initially, I expect some low tax rate to be imposed on Roth IRAs, but after we (the people) swallow that, the rates would increase. Where money is concerned, all bets are off with the government. Posted By Hank Eilts, Dallas, Texas : February 18, 2008 3:03 pm
I truly doubt that the government will take away Roth IRAs - the uproar would be HUGE! However, it is more feasible that they will change future tax rates, but this will not be something a Roth IRA holder would be concerned about when drawing out of this account. One thing this article doesn’t touch on is, while it may be worthwhile converting your traditional IRAs to a Roth, what happens if your income limits don’t allow you to contribute to it? Is it then worthwile? Posted By CFP(R), Chicago : February 17, 2008 3:38 pm
The Roth probably will never go away and Congress needs money and to close the Traditional IRA “loophole”. I expect them and other traditional pre-tax retirement programs (401k/403b) to disappear. I also expect the return of the 3 for 1 for Social Security after some more of the Boomers start to retire. I surely expect it to be in full force in 15 years, when I get ready to retire. Posted By James M., Tucson, Arizona : February 16, 2008 6:44 pm
I don’t think that they will make existing Roth accounts taxable, but they may forbid new contributions on those terms. If they want to tax Roth maney it is more likely they would switch to a federal sales tax and grant no exemptions for money taken from Roth accounts. Posted By Doug Gambrel, Rochester New York : February 15, 2008 9:59 am
The Roth-type accounts may go away, but they would never impose tax on amounts invested in Roth accounts prior to the repeal of the Roth. The tax code and regulations are rarely retroactive because it would undermine the reliability of the law. Prospective changes may occur, but anything you put in a Roth now will all but certainly be tax-free when you take it out. ON that note, we are in a relatively low tax rate period in our country’s history, so throw everything you can into a Roth now. By the time most people retire, tax rates will likely be higher, much higher. Posted By John, New York, NY : February 15, 2008 9:33 am
Because of Congress’s predilection to re-write the tax code, I’ll doubt the Roth IRA will remain tax free for a long time. People that seek that free income ,for the most part, have other income sources “so called rich”. Given the shortages in SS and Medicare Congress will be looking to tax everything they can. Posted By josie, austin tx : February 14, 2008 3:54 pm
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