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.