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.
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 in the process of changing jobs. He is over the age of 70 1/2 so instead of rolling over his 401k to an IRA he is going to roll it to his new 401k to avoid required minimum distributions. 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
As you can see, 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.
*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.
This post is featured in the Carnival of Pecuniary Delights at the Financial Blogger.
Securities offered through LPL Financial, Member FINRA/SIPC
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Excellent run-through of the need-to-know facts.
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Jeff – Another excellent post. I think there’s probably a good number of people who read up on the conversion rules online and figure they can go it alone. Not a bad idea if you simple situation with a single account completely funded in a certain way and you’re converting the whole thing.
But I think a lot of people fail to realize that the IRS views you as having only one IRA, even if you have one account with Fidelity and a second with Charles Schwab. You can’t simply convert the Fidelity account and ignore the Schwab account.
Your example shows just how complex some of these conversions can be, and even if you’re capable of doing the math, which I’m sure many of your readers are… It’s always a great idea to have a second pair of eyes looking things over. After all, skipping professional advice to save a few bucks doesn’t work if you get nailed by the IRS with unexpected taxes and/or penalties…!
Great article! I think I will be following your blog more and more. Quick question… I just opened and maxed out a traditional IRA this year (I’m 23 fresh out of grad school) and was doing some research (including reading your blog) and decided that a Roth IRA might be a better option for me. That said, if I convert my traditional IRA to a Roth IRA this year, considering that I have not taken advantage of the tax-breaks that the traditional IRA provides yet, can I do the conversion tax-free? Or will I still have to pay something?
Thanks!
@ Mark
Glad you enjoy the site. I hope you find it useful. The tax consequence of your decision will be minimal. The only cost associated with the transaction will depend on your IRA custodian (some may charge a fee for converting). Double check with them to see what costs you may entail.
In your final example (re Bentley), shouldn’t steps 2 and 3 use $346,000 instead of $6000?
@ David
No sir. We are trying to calculate the amount of of the conversion amount has to be treated as ordinary income. Since Bentley is only converting $6,000, that is the amount we use in the equation.
Thanks Jeff, great article.
I understand the math of converting to a Roth when you own both a non deductible IRA and a deductible IRA. My question is timing.
Currently I have only a non deductible IRA that I look forward to converting 100% to a Roth in 2010 (have to wait due to income). However, *later* in 2010 I have an old 401k that I plan to roll over to a regular IRA (new employer 401k investment options stink).
So I’m wondering if I can get away without doing the % allocation between deduct and non deduct IRA b\c when I do the conversion I will have *only* the non deductible. Or will 2010 be viewed in it’s entirety and include the time later in the year when I also have an after tax IRA (from the 401k rollover)?
If I have to, I’m assuming I can wait to convert the old 401K to an IRA the next year and 2010 will be cleared for the conversion to a Roth.
Thanks!
Sorry, I should have written:
“Or will 2010 be viewed in it’s entirety and include the time later in the year when I also have a *PRE* tax IRA (from the 401k rollover)?” …thus requiring the % allocation
Jeff,
Great article! I still have a quick question. Both my husband and I have pre-tax and after-tax traditional IRA accounts. We’re filing joint tax returns. If we convert only my traditional IRA accounts to Roth IRA but keep my husband’s accounts in traditional IRA, do I need to include my husband’s IRA balances in the calculation to determine after-tax portion of the conversion?
Thanks a lot for your clarification!
Thanks for the great article. One thing that I wasn’t quite clear on was the 2010 benefit of spreading the conversion income over 2011 and 2012. If I understand you correctly, I have the option of paying all the 2010 Roth conversion taxes when I file my 2010 taxes OR I can spread the taxable income over tax years 2011 and 2012, correct? If I would elect to spread the conversion taxable income over 2011 and 2012, then I don’t (can’t) attribute any of the Roth conversion in 2010. Ideally, I would want to spread out the 2010 conversion over the three tax years 2010, 2011, and 2012 to help ensure I stay in a lower marginal tax bracket. Is there a way to do this?
In calculating amounts in all IRAs for a joint filing do we need to add up all IRAs for both the husband and wife or is each set of IRAs (husband and wife’s seperate IRAs) treated seperately for calculating tax liability? Thanks
@ msb. You will just need to add the total amount for each party that is looking to convert. If the husband just wants to convert, then just add his and vice versa.
I have a question with regards to married couples and conversion. Are the IRA accounts considered separately? I have a larger rollover IRA, but my husband doesn’t have a rollover IRA. Is the percentage of non-deductible contributions calculated separately? i.e. his accounts separate from my accounts? Second question – can we choose separate tax treatment for his conversion than from mine? In other words, can we pay the taxes on his conversion in 2010 and defer the taxes on my conversion to 2011 and 2012?
@ Karen H
Yes, the are considered separately.
One spouse can elect to pay all tax in 2010, while the other can defer for 2011 and 2012.
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Best article I have seen on the complications of converting an IRA to a Roth IRA when you have multiple pre/post-tax IRAs. I wish other magazine articles had been as well researched. Can anyone answer above question from Karen? I believe individuals are treated seperately on form 8606 (but I’m no expert). Also in Jeff’s example of Bentley, does the $5894 tax payment convert a portion of his rollover IRA from pre-tax to post-tax? Seems like it would, but its not clear to me how you would keep track of it….