Roth conversions

Whether you are looking to convert Traditional IRA’s or 401k’s, here is a look at seven things that you need to know about the 2010 Roth IRA conversion rules.

1.  Rules on Income Limits.

Whether you are filing as an individual or married filing joint, the adjusted gross income level of $100,000 will become nonexistent for the Roth IRA  conversions of 2010.  For higher wage earners, this is a prime opportunity to convert money into the Roth IRA to allow your money to have tax-free growth at retirement.

2.  If you change your mind after you convert your Traditional IRA to Roth…

you can always do an IRA recharacterization by October 15th of year you convert.

3.  2010 is the year of conversion but not the year the tax is due.

While 2010 is the actual year that you will be able to convert, the income to be claimed can be deferred until 2011 and 2012.  Expecting a vast majority to take advantage of this, the IRS has set up special provision on how the tax will be paid.  The IRS has granted you the option to claim 50% of the conversion amount as income in 2011 and the remaining 50% in 2012.  Keep in mind that this is only in 2010.  After 2010 the taxes will all be paid in full the following year going forward.

If you elect to pay the tax over the two year period, keep in mind that the tax rate is determined for that year only.   Example, in 2011 you will pay the tax based on your tax bracket for that year.   If your income were to somehow sky rocket in 2012, then you will be paying more in taxes that year for the conversion.

What if husband and wife want to convert? Each IRA(s) is tied directly to the Social Security number of the account owner.  What that means is that if a husband wants to convert his IRA’s and the wife does not, that’s okay.  Further more, if both want to convert, then the husband can choose the two year option on paying the tax and the wife could choose to pay her tax in 2010 (or vice versa).  Remember that you have to do one or another.  For example, if the husband has multiple IRA’s that he is looking to convert, he can’t choose to pay the tax this year on one IRA, then defer the other IRA for 2011 and 2012.

4.  Convert but Can’t Contribute

Just because the conversion limit of $100,000 AGI is lifted, doesn’t mean that the income restrictions are lifted for new contributions into the Roth.  If you’re over the phase out limits of the Roth IRA contribution, you will not be  able to contribute new money to the Roth.  There is a backdoor approach to this and that allows you contribute to a non-deductible IRA and then right immediately after wards convert it to a Roth IRA and avoid all taxable consequence.  It’s a nice loophole that still allows you to continue to contribute to the Roth and benefit from the tax-free money.

5.  Convert Traditional IRAs and Old 401(k)s.

The 2010 conversion is not limited to just your traditional IRA.  If you have any old 401(k)s or any other retirement plans from a previous employer, those will also be allowed to convert as well.  Might be a good idea to convert them all.  Be conscious if you are converting after tax contributions in an IRA (non-deductible IRA).  The tax rules can get a bit complicated.  Follow these steps to figure out how much tax you will owe.

6.  What’s the Cost Basis?

If you have an old 401(k) that you have rolled over into an IRA, the question might be what do you use as the original tax basis?  In  the face of the 2010 conversion or any conversion in general the basis, or the amount that you will be taxed on, is the amount of the account at the time of conversion.  For example, if you had an old 401(k) that was worth $45,000 and rolled it over into an IRA, and now that IRA is only valued at 25,000, the 25,000 is the amount you’ll use for your basis.  If you elect to do the conversion at 25,000 and then as the year goes by and the account drops more, the option might able to do what’s called an IRA recharacterization.

*Restrictions, penalties and taxes may apply.  Unless certain criteria is met, Roth IRA owners must be 59 1/2 or older and have held the IRA for 5 years before tax-free withdrawals are permitted.

Roth IRA Conversion Calculators: Should You Convert?

January 26, 2010

2010 is the year of the mighty Roth IRA conversion and many boomers are wondering if it’s the right thing to do.  The sound of tax-free money is a sweet lullaby, but is it worth the up front tax expense?Everybody’s situation is different and it’s hard to say if it’s right for you.  If you are on the bubble, here’s a comprehensive list of Roth IRA conversion calculators that you can plug in some numbers and see if it makes sense.

Reasons to do a Roth IRA Conversion

There are several reasons that a Roth IRA conversion makes complete sense.  Here are a few:

  • A larger sum to bequeath to heirs. Since required minimum distributions (RMDs) do not apply for Roth IRAs as they do for traditional IRAs, investors who do not need the money may leave it invested as long as they choose, which may result in a larger balance for heirs. After an account owner’s death, beneficiaries are required to take distributions, although different rules apply for spouses as opposed to children and other non-spousal beneficiaries.
  • Tax-free withdrawals on qualified distributions. Withdrawals from a Roth IRA are tax-free for those who have had the money invested for five years or more and have reached the age of 59½ or have attained another qualifying event.

Which Is Right for You?

If you have a traditional IRA and are considering converting to a Roth IRA, here are a few factors to consider:

  • A conversion may be more attractive the further you are from retirement. The longer your earnings can grow, the more time you have to compensate for the associated tax bill.
  • Your current and future tax brackets will affect which IRA is best for you. If you expect to be in a lower tax bracket during retirement, sticking with a traditional IRA could be the best option because your RMDs during retirement will be taxed at a correspondingly lower rate than amounts converted today. On the other hand, if you anticipate being in a higher tax bracket, the ability to take tax-free distributions from a Roth IRA could be an attractive benefit.

There is no easy answer to the question: “Should I convert my traditional IRA to a Roth IRA?” As with any major financial consideration, careful consultation with a professional is a good idea before you make your choice.

List of Roth IRA Conversion Calculators

Disclaimer: Roth IRA conversion calculators are not created equal.A calculator — whether found on the web or nestled in a more sophisticated financial planning software package — isn’t a bad jumping-off point when trying to assess whether it makes sense for someone to convert his or her retirement assets to a Roth individual retirement account. But it is hardly the final word on the matter.  Be sure to meet with a Certified Financial Planner or tax advisor before implementing the Roth IRA conversion.

If you plan to cash in on the favorable Roth conversion rules this year…

Consider using separate Roth IRAs for different asset classes. That way,
if one segment of your Roth investments drops while the others increase in value,
you can switch the underperforming account back to an IRA tax and penalty free.
This strategy gives you maximum flexibility. If you timely file your 2010 return,
you will have until Oct. 17, 2011 to decide whether you are better off unconverting.
The $100,000 adjusted gross income limit on conversions ended after Dec. 31, 2009,
and anyone converting this year can elect to defer the income tax bill on the switch.
Half the income can be reported on 2011 returns and the balance the following year.
Seniors who are thinking of converting should note a couple of tax traps:
The extra income from converting can affect Medicare Part B premiums.
Upper incomers have to pay a monthly surcharge on top of their regular premium.
The surcharge starts at $85,000 of AGI for singles and $170,000 for married couples,
rising to 220% of the basic premium for single filers with income above $214,000
and married couples with AGI over $428,000. In computing AGI for the surcharge,
Roth conversion income is counted. That can cause Part B premiums to increase
by up to about $3,000 a year per person. So if you report all that income in 2010
you may see your 2012 premium skyrocket. If you spread the conversion income
over 2011 and 2012, you may owe higher Part B premiums in 2013 and 2014.
There’s a similar effect with Social Security benefits. Lower income seniors
who convert may see more of their benefits taxed because of that additional income.
But seniors won’t have to take required minimum payouts from their Roths.
That will trim their AGIs in future years. And any payouts they take will be tax free.