In 1982 the Violent Femmes released the title track to their debut album “Gone Daddy Gone” that went on to be an epic album. Almost just an epic event is the lifting of the $100,000 AGI (Adjusted Gross Income) restriction for individual or couples that are looking to do a Roth IRA Conversion. As it stands right now, for any tax payer no matter your filing status, you are unable to do a conversion if you exceed this limit. Most everybody knows (if not, then you know now) that in 2010 these restrictions are lifted and anyone and their brother will be able to do the Roth Conversion. If this applies to you, here are some tips to get you prepared for the Roth IRA Conversion event when the restrictions are officially “gone daddy gone”.
2010 the AGI Limits are "Gone Daddy Gone"
If this article was helpful, you may also want to check out these posts as well: 7 Things To Know About The 2010 Roth IRA Conversion, Roth IRA Time To Convert, 7 Things To Know About Roth IRA 2009.
Start Preparing Now For The Conversion
Basically, there are two ways that you can prepare you for the Roth conversion in 2010.
Initially, you need to review all of your old retirement plans that you may have. This can include: traditional IRA’s, SEP IRA’s, Simple IRA’s, old 401k’s, old 403b’s. Once you get those sorted out, add them up to get an approximate total value. Once you get the sum, you’ll now have a sense of what your tax bill will be. A couple things to consider:
- Most likely your accounts are down if they were anywhere close to the stock market. This could make it that much more of an attractive opportunity to convert.
- Remember that when you convert in 2010, you have the option to deferring the tax over 2011 and 2012 at a 50/50 split. This option is only available in 2010.
Also, keep in mind that although you can split the tax between those two years (2011 and 2012), the actual tax that is due will be based on your tax bracket in that year.
Example
You have a $50,000 old traditional IRA that you want to convert to a Roth IRA in 2010. You elect to split it over the 2011 and 2012 tax years so that you claim $25,000 of ordinary income in 2011 and then again in 2012. If for some reason your income is abnormally higher (raise in salary as an example) in 2011, you’ll end up paying more in tax that year than you would have previously. In short, it’s not based on your tax bracket in the 2010 year.
The “Backdoor” into a Roth IRA using Traditional IRA
photo credit: Shawn Semmes
Many people have wanted to take advantage of the Roth IRA for the past several years, but couldn’t because they surpassed the Roth IRA phaseout limits. Many then settled for the pretax substitute of the traditional IRA. The only problem with the traditional IRA (other than paying taxes at retirement) is that after certain income limits you no longer get a tax deduction for contributing to one. You still get the tax deferred growth, but that’s it.
If you are an active participant (making annual additions or accruing a benefit) in a company plan and make more than $65,000 as a single taxpayer in 2009 (or $109,000 as a married joint taxpayer) then you are disqualified from taking the full deduction. What you are then left with is the nondeductible IRA.
Introducing the Nondeductible IRA
In the past, there was nothing all that attractive about the nondeductible IRA. With 2010 just around the corner, the nondeductible IRA has become a very popular tool to allow high wage earners a way into the Roth IRA- a “backdoor” way. A high wage earner can contribute to a nondeductible IRA with the sole intentions of converting it in 2010.
By contributing to the nondeductible IRA, you will only be responsible to pay what gains you’ll have from now until you convert in 2010. If 2009 will be the first year to contribute, then unless you happen to pick a one in a million shot, your tax liability should be minimized.
The Five Year Rule
One last consideration when converting to a Roth IRA is the five year rule. As when you make a contribution into a Roth IRA, you have the same five year holding period for the earnings applies to the conversion amount. This is the amount that you will be able to take tax and penalty free. (Remember: When you contribute new money to a Roth IRA its only the earnings that have to wait 5 years not the contributions). Here’s a few things to consider:
- The five year holding period begins January 1st of the year that you convert. For example, if you converted on November, 1st 2008 then the five year holding period began on January 1st of that year.
- If you have already converted in the past, then each new conversion begins a brand new 5 year holding period. Let’s say you were able to previous able convert in 2006 and you plan to convert again in 2010, then each of those conversions would be subject to their own 5 year holding period.
- Lastly, if you decide to convert and then change your mind, you always have the option to recharacterize. Recharacterization of an IRA is the equivalent to a mulligan on the golf course.
*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.
Securities offered through LPL Financial, Member FINRA/SIPC
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Jeff, another beautiful post (yup, I’m a money nerd, this stuff is beautiful to me).
One point to spell out clearly for your readers;
Say you have a mix of pre and post tax IRA money, (Not 401(k), just IRA here) even though you may have started and made deposits to an account you treated as “Non-Deductible” IRA, you need to add up all the accounts to determine what’s taxable upon conversion. Example. You have $50K in a traditional (pre-tax) IRA. You also have your Non-deducted IRA balance of $50K, which is the current balance from deposits made totaling $40K, i.e. $10K growth. Now, when you convert money from the IRA* 60% is considered taxable, regardless of which account it’s pulled from for conversion.
*I purposely say “the IRA” because as far as the IRS is concerned you only have one. It’s made up of pretax and possibly post-tax money, but regardless of the number of accounts it’s in, you still have one IRA. By the way, IRA stands for Individual Retirement Arrangement, not Account.
If you plan to convert Nondeducted money, be careful not to roll your 401(k) account to an IRA first as that money will become part of the equation. This is not that complicated, so long as you pay attention and do it right.
Joe
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Thanks for diving into that. I actually started to mention that, but thought it might get too “gritty” for this post. Your explanation (as your blog) is spot on. Good job!
Another consideration than just brackets if you defer your 2010 conversion into 2011/12 is that the rates may change due to either 1. expiration of the bush rate reductions; 2. any new changes made to the tax law. So the analysis will be the time value of money at your 2010 rate vs an estimate of what your marginal rate in 2011/12 might be. Given much of the legislative activity points to tax increases rather than decreases its something to factor.
We are doing well, so I am leaning against taking the interest free loan and taking my lumps in 2010.
Good article. Read it all and had already decided that I would be converting both of our IRA’s to Roth’s next year. I’m beyond 70 1/2 and my wife will be next year.