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 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.

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.

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 IRA 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:

1. 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.
2. 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

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:

1. 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.
2. 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.
3. 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

Remember when 2010 seemed like light years away?  2010 is here! We’re one month into 2010 and pretty soon will be seeing the ball drop again.  2010 brings a lot of uncertainty within the financial realm with estate planning and sunset provisions in question.

One thing that is certain pertains to the Roth IRA. The 2010 Roth IRA conversion is just here.  Many still are left confused about the rules and not completely certain of what the conversion really means to them. Whether you are looking to convert Traditional IRA’s or 401k’s, here is a look at seven things that you need to know about the 2010 Roth IRA conversion rules.

Reminder: Deadline for converting 401k’s and Traditional IRA’s is December 31st!

If this article was helpful, you may also want to check out these posts as well:7 Things You Need to Know About the Roth IRA for 2010, Roth IRA Conversion Tax Rules, Can You Undo a Roth IRA Conversion?

1.  Rules on Income Limits.

Whether you are filing as an individual or married filing joint, the adjusted gross income level of $100,000 will become nonexistent for the Roth IRA  conversions of 2010.  For higher wage earners, this is a prime opportunity to convert money into the Roth IRA to allow your money to have tax-free growth at retirement.

2.  You don’t have to wait until 2010.

For wage earners that make less than $100,000 adjusted gross income, you can actually convert now.  With the market being down what it is this might be an excellent time to convert since you will be paying less income tax on the lower account value.  By waiting until 2010, and if you are able, you may be having to pay a higher tax bill with market appreciation.  If you convert too soon, you can always do an IRA recharacterization by October 15th of year you convert.

3.  2010 is the year but not the year the tax is due.

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.

What if husband and wife want to convert? Each IRA(s) is tied directly to the Social Security number of the account owner.  What that means is that if a husband wants to convert his IRA’s and the wife does not, that’s okay.  Further more, if both want to convert, then the husband can choose the two year option on paying the tax and the wife could choose to pay her tax in 2010 (or vice versa).  Remember that you have to do one or another.  For example, if the husband has multiple IRA’s that he is looking to convert, he can’t choose to pay the tax this year on one IRA, then defer the other IRA for 2011 and 2012.

4.  You can save taxes now.

Knowing that the event is just around the corner, and if you know that you are going to convert in 2010, it might make sense to go ahead and start accumulating the tax money now.  Since you will be taxed at ordinary income levels  you can get a sense of what the tax bill will actually be at the time of conversion.  So why not add a little extra to your emergency fund to insure that you have enough to pay the tax bill for this exciting event?

5.  Convert but Can’t Contribute

2010 Conversion

Just because the conversion limit of $100,000 AGI is lifted, doesn’t mean that the income restrictions are lifted for new contributions into the Roth.  If you’re over the phase out limits of the Roth IRA contribution, you will not be  able to contribute new money to the Roth.  There is a backdoor approach to this and that allows you contribute to a non-deductible IRA and then right immediately after wards convert it to a Roth IRA and avoid all taxable consequence.  It’s a nice loophole that still allows you to continue to contribute to the Roth and benefit from the tax-free money.

Please note: If you have pre-tax traditional IRA’s already established, the IRS will treat all them as one IRA in the conversion process and you may have to pay a pro-rata tax on the non-deductible IRA.  You can read more about the tax rules of the Roth IRA conversion.

6.  Convert Traditional IRAs and Old 401(k)s.

The 2010 conversion is not limited to just your traditional IRA.  If you have any old 401(k)s or any other retirement plans from a previous employer, those will also be allowed to convert as well.  Might be a good idea to convert them all.  Be conscious if you are converting after tax contributions in an IRA (non-deductible IRA).  The tax rules can get a bit complicated.  Follow these steps to figure out how much tax you will owe.

7.  What’s the Cost Basis?

If you have an old 401(k) that you have rolled over into an IRA, the question might be what do you use as the original tax basis?  In  the face of the 2010 conversion or any conversion in general the basis, or the amount that you will be taxed on, is the amount of the account at the time of conversion.  For example, if you had an old 401(k) that was worth $45,000 and rolled it over into an IRA, and now that IRA is only valued at 25,000, the 25,000 is the amount you’ll use for your basis.  If you elect to do the conversion at 25,000 and then as the year goes by and the account drops more, the option might able to do what’s called an IRA recharacterization.

Update: Check out my latest post that shares some real life scenarios and tax consequences of converting a Traditional IRA  to a Roth IRA. Also, check out this post I found on different Roth IRA conversion calculators.

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

The 2010 Roth IRA Conversion event can’t get here soon enough.  As you may know, this is the time that anybody will be able to convert their traditional IRA’s to Roth IRA’s no matter your income level.  But currently as it stands now, if you make over $100,000 AGI Married Filing Jointly, your left counting the days until you are allowed to do so.

Common Misconception on Converting

A few people I’ve talked with thought that everybody had to wait to convert until 2010.  This is not the case. In fact, for many of you that have been contemplating whether to convert your former traditional IRA to a Roth IRA, now might be the year to do it.  With the recent decline in the market for 2008, chances are you’ve seen your investment accounts drop in significant value.  If you have a traditional IRA or a 401(k) at a previous employer, this might be the opportunity to convert that into a Roth IRA.

Why Is This A Good Time To Convert to a Roth IRA?

Reason being, when you convert to a Roth IRA, you have to pay the ordinary income tax on the converted amount.   By converting this year, your IRA’s have most likely dropped significantly and you will then have less to pay ordinary income tax with.  Sure it’s not exciting to see your account drop 30-40%, but if you could sock that away in a Roth IRA, think of all the tax free money down the road……woo-hoo!

Roth IRA Conversion Example

If your traditional IRA or previous 401(k) is worth $15,000, that would mean that you would have to claim $15,000 of income that year and then pay the according tax.  But let’s say that same 15,000 is currently worth $10,000 due to the recent market downturn, you then would pay less ordinary income tax on the converted amount; thus making it a timely opportunity to convert to a Roth IRA in a down market.

Before You Get Too Excited

Please keep in mind that currently if you individually or jointly make over $100,000 or modified adjusted gross income, you cannot take advantage of this opportunity.  Your first window of opportunity will not be until the year 2010, which then depending on the value of the accounts  might be another time of considering converting to a Roth IRA.

Update: Check out my latest post that shares some real life scenarios and tax consequences of converting a Traditional IRA to a Roth IRA.

Other good reads:

• Moment On Money: Every Cloud Has a Silver Lining
• Five Cent Nickle: Roth IRA Conversion In a Down Market
• My Dollar Plan: Roth IRA Conversions

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