Roth IRA Conversions--Act Now to Take Advantage of New Rules
With the lure of tax-free distributions, Roth IRAs have become popular
retirement savings vehicles since their introduction in 1998. But if
you're a high-income taxpayer, chances are you haven't been able to participate
in the Roth revolution. Well, that's about to change.
What are the current rules?
There are currently three ways to fund a Roth IRA--you can contribute
directly, you can convert all or part of a traditional IRA to a Roth
IRA or you can roll funds over from an eligible employer retirement plan. More on this third method later.
In general, you can contribute up to $5,000 to an IRA (traditional,
Roth or a combination of both) in 2008 and 2009. If you're age 50 or older, you can contribute up to $6,000 in 2008 and 2009. (Note, though, that your contributions can't exceed your earned income for the year.)
But your ability to contribute directly to a Roth IRA depends on your
income level ("modified adjusted gross income," or MAGI), as
shown in the chart below:
| If your federal filing status is: |
Your 2009 Roth IRA contribution is reduced if your MAGI is: |
You can't contribute to a Roth IRA for 2009 if your MAGI
is: |
| Single or head of household |
More than $105,000 but less than $120,000 |
$120,000 or more |
| Married filing jointly or
qualifying widow(er) |
More than $166,000 but less than $176,000 |
$176,000 or more |
Married filing
separately |
More than $0 but less than $10,000 |
$10,000 or more |
Regardless of whether you contribute directly to a Roth IRA, if your
MAGI is $100,000 or less and you're single or married filing jointly,
you can convert an existing traditional IRA to a Roth IRA. (You'll have
to pay income tax on the taxable portion of your traditional IRA at the
time of conversion.) But if you're married filing separately, or your
MAGI exceeds $100,000, you aren't allowed to convert a traditional
IRA to a Roth IRA.
What's changing?
In 2006, President Bush signed the Tax Increase Prevention and Reconciliation
Act (TIPRA) into law. TIPRA repeals the $100,000 income limit for conversions,
and also allows conversions by taxpayers who are married filing separately.
What this means is that, regardless of your filing status or how much
you earn, you'll be able to convert a traditional IRA to a Roth IRA.
The bad news? This provision of the new law doesn't take effect until
2010.
So why concern yourself with this now?
Even though the new rules don't take effect until 2010, there are steps
you can take now if you want to maximize the amount you can convert at
that time. If you aren't doing so already, you can simply start making
the maximum annual contribution to a traditional IRA, and then convert
that traditional IRA to a Roth in 2010.
Your ability to make deductible contributions to a traditional IRA
may be limited if you or your spouse is covered by an employer retirement
plan and your income exceeds certain limits. But any taxpayer, regardless
of income level or retirement plan participation, can make nondeductible
contributions to a traditional IRA until age 70½. And because
nondeductible contributions aren't subject to income tax when you convert
your traditional IRA to a Roth IRA, they make sense for taxpayers contemplating
a 2010 conversion even if they're eligible to make deductible contributions.
And don't forget that SEP IRAs and SIMPLE IRAs (after two years of participation) can also be converted to
Roth IRAs. You may want to consider maximizing your contributions to these
IRAs now, and then converting them to Roth IRAs in 2010. (You'll need
to set up a new IRA to receive any additional SEP or SIMPLE contributions
after you convert.)
But there's a taxing problem
If you've made only nondeductible contributions to your traditional
IRA, then only the earnings, and not your own contributions, will be
subject to tax at the time you convert the IRA to a Roth.
But if you've made both deductible and nondeductible IRA contributions
to your traditional IRA, and you don't plan on converting the entire
amount, things can get complicated.
That's because under IRS rules, you can't just convert the nondeductible
contributions to a Roth and avoid paying tax at conversion. Instead,
the amount you convert is deemed to consist of a pro-rata portion of
the taxable and nontaxable dollars in the IRA.
For example, assume that in 2010 your traditional IRA that contains $350,000
of taxable (deductible) contributions, $100,000 of taxable earnings,
and $50,000 of nontaxable (nondeductible) contributions. You can't convert
only the $50,000 nondeductible (nontaxable) contributions to a Roth.
Instead, you'll need to prorate the taxable and nontaxable portions of
the account. So in the example above, 90% ($450,000/$500,000) of each
distribution from the IRA in 2010 (including any conversion) will be taxable, and 10% will
be nontaxable.
You can't escape this result by using separate IRAs. The IRS makes
you aggregate all your traditional IRAs (including SEPs and SIMPLEs)
when calculating the taxes due whenever you take a distribution from
(or convert) any of the IRAs.
But for every glitch, there's a potential workaround. In this case,
one way to avoid the prorating requirement, and to ensure you convert
only nontaxable dollars, is to first roll over all of your taxable IRA
money (that is, your deductible contributions and earnings) to an employer
retirement plan like a 401(k) (assuming you have access to an employer
plan that accepts rollovers). This will leave  only the nontaxable money
in your traditional IRA, which you can then convert to a Roth IRA tax
free. (You can leave the taxable IRA money in the employer plan, or roll
it back over to an IRA at a later date.)
But even if you have to pay tax at conversion, TIPRA contains more
good news--if you make a conversion in 2010, you'll be able to report
half the income from the conversion on your 2011 tax return and the other half on
your 2012 return.
For example, if your only traditional IRA contains $250,000 of taxable dollars
(your deductible contributions and earnings) and $175,000 of nontaxable
dollars (your nondeductible contributions), and you convert the entire amount to
a Roth IRA in 2010, you'll report half of the income ($125,000) in 2011,
and the other half ($125,000) in 2012.
And speaking of employer retirement plans...
Before 2008, you couldn't roll funds over from a 401(k) or other eligible employer
plan directly to a Roth IRA unless the dollars came from a Roth 401(k)
account or a Roth 403(b) account. In order to get a distribution of non-Roth dollars from your employer plan into a Roth IRA, you needed to first
roll the funds over to a traditional IRA and then (if you met the income
limits and other requirements) convert the traditional IRA to a Roth
IRA. And, as described earlier, you needed to aggregate all your traditional
IRAs to determine how much income tax you owed when you converted the
traditional IRA.
The Pension Protection Act of 2006 streamlined this process. Now, you can simply roll over a distribution of non-Roth dollars from a 401(k) or other eligible plan directly (or indirectly in a 60-day rollover) to a Roth IRA. You'll still need to meet the $100,000 income limit for
2008 and 2009. And you'll still need to pay income tax on any taxable
dollars rolled over.
One benefit of this new procedure is that you can avoid the proration
rule, since you're not converting a traditional IRA to a Roth IRA. This
can be helpful if you have nontaxable money in the employer plan and
your goal is to minimize the taxes you'll pay when you convert.
For example, assume you receive a $100,000 distribution from your 401(k) plan,
and $40,000 is nontaxable because you've made after-tax contributions. You can
roll the $60,000 over tax free to a traditional IRA, and then roll the after-tax
balance ($40,000) over to a Roth IRA. Since only after-tax dollars are
contributed to the Roth IRA, this rollover is also tax free. (Both your plan's
terms, and the order in which
you make the rollovers, may be important, so be sure to consult with us.)
Is a Roth conversion right for you?
The answer to this question depends on many factors, including your
income tax rate, the length of time you can leave the funds in the Roth
IRA without taking withdrawals, your state's tax laws and how you'll
pay the income taxes due at the time of the conversion. And don't forget--if you
make a Roth conversion and it turns out not to be advantageous, IRS rules allow
you to "undo" the conversion (within certain time limits).
We can help you decide whether a Roth conversion
is right for you, and help you plan for this exciting new retirement
savings opportunity. Please contact us to discuss.
Prepared by Forefield Inc. Copyright 2009 Forefield Inc. |
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