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?
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.
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!
*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.
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