2010 Traditional IRA to Roth IRA Conversion Tax Rules

2010 Roth IRA Conversion Event is just around the corner.  Here are the tax rules if you are considering the conversion.

2010 is literally just around the corner- where did 2009 go?  As the new year approaches I keep getting more inquiries about the 2010 Roth IRA Conversion Event and more specifically what are the tax rules and implications of doing the conversion from a traditional IRA to a Roth IRA.  To help illustrate how the conversion could impact you tax wise, I thought it would be easiest to share some examples.  Before we get into the nitty gritty, let’s recap how the tax exactly works next year.

Recap of 2010 Conversion Event

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.

Please Note: The ability to spread the tax over a two year period expired after 2010. You can still do the Roth IRA conversion, you just have to pay all the tax in the year that you convert. Read my updated post on the Roth IRA Rules for 2011 for more information.

Traditional IRA To  Roth IRA Conversion Tax Example

Converting in 2010 can be extremely tricky.  What makes it so tricky is that when it comes to converting an IRA, the IRS will look at all your IRA’s as one.  For example, if you have a traditional IRA at a bank, another at a brokerage firm, and a Simple IRA from an old employer, the IRS looks at those as one IRA.  What makes it even more complicated is if your have a combination of pre-tax and after-tax contributions.  Before I muddy the waters even more, let’s look at an example.

Parker has a SEP IRA, a Traditional IRA, and a Roth IRA totaling $310,000.   Let’s breakdown the pre and post tax contributions of each.

  • SEP IRA: Consists entirely of pre-tax contributions.   Total value is $80,000 with pre-tax contributions of $12,000.
  • Traditional IRA: Consists entirely of after-tax contributions.  Total value is $200,000 with after-tax contributions of $40,000.
  • Roth IRA: Obviously all after tax contributions.  Total value is $30,000 with total contributions of $7,000.

Parker is wanting to only convert half of the amount in his SEP and Traditional IRA’s to the Roth IRA.   What amount will be added to his taxable income in 2011 and 2012?

Quick Summary

We have $40,000 total after-tax contributions to non-Roth IRA’s.  The total non-Roth IRA balance is $280,000.  The total amount that is desired to be converted is $140,000.

How To Calculate The Tax

Step 1: Calculate non-taxable portion of total Non-Roth IRA’s

Total after-tax contributions  /  Total Non-Roth IRA Balance = Non-Taxable %

$40,000  /  $280,000 =  14.29%

Step 2:  Calculate the non-taxable amount by converting the result to Step 1 into dollars

14.29%    x   $140,000 =  $20,000

Step 3:  Calculate the amount that will be added to your taxable income

$140,00 – $20,000 =  $120,000

In this scenario, Parker will owe ordinary income tax on $120,000.

Another Roth IRA Conversion Example

Whew! A little too much math in that last example, huh?   As I mentioned earlier, converting to a Roth IRA can be a very complicated procedure.  That’s why it’s important to work with a tax professional to make sure you fully understand the tax implications.  To make sure you have a good understanding on the tax implications of the Roth IRA Conversion, let’s look at another scenario that I helped a client on recently.

Bentley is over the age 0f 50 and in the process of changing jobs.   Because his employer had been bought out a few times, he has rolled over previous 401k’s into two different IRA’s.  One IRA totals $115,000 and the other consists of $225,000.  Since he’s never had a Roth IRA, he’s considering contributing to a nondeductible IRA  for a total of $6,000 then immediately converting in 2010.

  • Rollover IRA’s: Consists entirely of pre-tax contributions.   Total value is $340,000 with pre-tax contributions of $150,000.
  • Old 401k: Also consists entirely of pre-tax contributions. Total value is $140,000 with $80,000 pre-tax contributions.
  • Current 401k: Plans out maxing it out for the rest of his working years.
  • Non-deductible IRA: Consists entirely of after-tax contributions.  Total value will be $6,000 of after-tax contributions and we will assume no growth.

Based on the above information, what will be Bentley’s tax consequence in 2010?

Did you notice the curve ball I threw in there?  Sorry, didn’t mean to trick anybody.  I just wanted to see if you caught it.  When it comes to converting, old 401k’s and current 401k’s do not factor into the equation.   Remember this if you are planning on considering on converting large IRA balances and have an old 401k.  By leaving it in the 401k, it will minimize your tax burden.

Using the steps from above, let’s see what Bentley’s taxable consequence will be in 2010….

Step 1. $6,000/ $346,000 = 1.73%

Step 2.  1.73% X $6,000 = $103.80

Step 3. $6,000 – $103.80 =  $5,896.20

For 2010, Bentley will have a taxable income of $5,894.12 of his $6,000 Roth IRA contribution and that’s assuming now growth.  As you can see, you have to be careful  when initiating conversion.

Conclusion

Converting your old IRA’s can get very complicated very quick.  I would advise you to not go at it alone.  Consult with a Certified Financial Planner and/or a tax professional before implementing this strategy.  Good luck!

Special Thanks to Joe from Joe Taxpayer.  It was his comments that inspired me to write this post.  Check out one of his posts on the Roth IRA.

Creative Commons License photo credit: Zach K

*Restrictions, penalties and taxes may apply.  Unless certain criteria are 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.

Related Posts with Thumbnails

Get the Money Dominating Toolkit

Sign up for free below and get the following:

  • 6 Tools to Get Your Money Back on Track
  • The Ultimate Goal Achiever Workbook
  • 2 Free Chapters to my Best Selling Book
  • 21 Days to Destroy Your Bad Habits Worksheet

Comments | 3 Responses

  1. Steve Armstrong says

    Hi Jeff, thank you for taking the time to explain the complications.

    I’ve been fighting with my Smith Barney investment advisors for almost two weeks now regarding two $6,000 after tax traditional IRA we took out in early 2010 to apply to 2009. We were told we could convert later in 2010 without incurring any added taxes. I was confused to say the least with the results I was getting from running TurboTax. I went in circles with Smith Barney until I’ve finally threw in the towel.

    In addition to doing two $6,000 Roth conversion, I rolled over $105,000 from my 401k plan, which by year’s end was valued at $110,000. My wife had rolled over $34,000 into a traditional IRA in 2009, which by the end of 2010 was valued at $40,000. Form 8606 (which is calculated when running TurboTax) showed $5700 of the $6000 was taxable (110,000/116,000 times 6,000). My marginal tax rate is 25%, so I have a choice to pay $1422 this year, or split the $5700 of increased income until l 2011 and 2012. If my marginal rate stays the same, I’ll just defer paying the taxes.

    It was a shock to find out we could owe $2726 for 2010, rather than $0 as we were led to believe. Of course we could split the payment over 2 years which is what we were going to do. Either that, or re-characterize to reverse the Roth back into a non-deductible traditional IRA.

    I came up with second strategy for myself. Since I’m “retired”, I am able to amend my 2009 return to change my non-deductible traditional IRA into a deductible IRA. I am no longer able to contribute to my company’s 401k, I’m over 59 1/2, so I eligible. This allows me to get an amended return for 2009 (roughly $1500). I can take a deductible IRA for 2010 also. This is even though we are way over the AGI threshold. Since I’ve already converted the 2009 contribution to Roth, I’ll end up paying taxes on the $6,000, but on $3,000 in 2011 and $3,000 in 2012. Since my wife just retired, our AGI for 2011 and 2012 will be a lot lower than previous. I’m guessing we’ll be in the 15% marginal rate bracket. so 15% of $12,000 worth of my two conversions will generated $1800 in owed taxes going forward, whereas, the reduction in taxes 2009 and 2010 is $3,000. So assuming, a 10% difference in marginal rate, I could end up paying $1200 less in taxes, while deferring paying them by 2 years.

    In my wife’s case, the numbers crunch out to a taxable income increase of $5217 (40/46 time 6,000). At 25% (take the hit all at once), our taxes would increase $1304 for 2010 (or could be split to 2011 and 2012). Our MAGI is apparently too high, so she can’t amend the return to make her’s deductible.

    I’m guessing my explanation is probably confusing.

    I’d appreciate it a lot, if you could confirm whether I understand how all this works, or add what I missed or don’t understand. It would be wonderful, if I could somehow convince my Smith Barney folks, they are the ones who are doing their taxes wrong. I’d like to believe them, as doing it their way could save me a lot in taxes.

    My wife has had it up to here with listening to me talk about this issue. She is begging me to let someone do my taxes next year and going forward. You seem to have a good handle on this apparently confusing issue.

    I’d like to have my tax guru where I live. But even more important, is I like my tax man to be a tax guru to start with. My Smith Barney advisor called her CPA to verify that converting to a Roth IRA is not taxable. NEVER, NEVER. I think there is at least one exception. Please let me know.

    Steve

  2. chuck says

    Can I convert monies in my IRA to my wife’s ROTH

    I am 69, she is 70: we are both retired without earned income.

    • Jeff Rose says

      @ Chuck You can’t commingle IRA’s. If you convert your IRA, it would have to go into your Roth. Income is a moot point as you can convert anytime you want.

Leave a Reply

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>