The critical decision of whether to convert a traditional IRA to a Roth IRA continues to provoke questions and cause some confusion. I thank all of you who sent me your questions, details about your unique circumstances, and responses you’ve received from the IRS and others. Today we review some key points that seem to be confusing or that are gray areas in the rules.
The option to defer taxes on the conversion sparks interesting questions from people considering creative strategies.
Start with the case of a married couple. If each chooses to convert an IRA in 2010, how does the deferral option work? Can one spouse choose to defer taxes and the other choose to pay taxes in 2010? The answer is yes. The IRAs are tied to the Social Security number of the account owners, not to the tax return. Each spouse can independently choose which tax payment option to take. Just to be clear, if one spouse converts an IRA, the other spouse does not have to convert.
What about an individual who converts several IRAs or who converts portions of the same IRA at different times during the year? The language of the tax code leaves open the possibility that he could decide to defer taxes on one conversion but pay the taxes in 2010 on the other conversion. The IRS is closing that door. It is advising people that for each IRA owner, the decision of whether or not to defer the conversion taxes applies to all IRAs that owner converts during the year. You can’t choose to defer taxes on one converted IRA and pay the taxes in 2010 on another converted IRA.
The five-year waiting period also generates many questions.
Only qualified distributions from a Roth IRA are tax-free. For a distribution to be qualified, the Roth IRA must be open at least five years. For regular Roth IRA contributions, the five-year rule is met if any Roth IRA owned by the taxpayer is at least five years old. If you opened a Roth IRA in 2000, for example, any distributions you take out of any regular Roth IRA now are tax-free.
The rule is different for converted Roth IRA amounts. A new five-year waiting period starts for each conversion. That means income and gains from the converted amount are taxable if withdrawn within five years of the conversion.
For most people, however, the five-year waiting period doesn’t matter. The rules for taxing Roth IRA distributions are that distributions are first considered to be of after-tax contributions. Distributions of after-tax contributions (such as converted amounts on which you paid the conversion tax) are tax-free. Only after all after-tax contributions (whether regular contributions or converted amounts) are withdraw are you withdrawing potentially taxable income and gains. So, the five-year rule doesn’t matter, unless you withdraw all or most of the IRA within five years. Even then, you’ll pay taxes only on the accumulated income and gains distributed not on the after-tax contributions.
The five-year period for either type of contribution begins on Jan. 1 of the year of the contribution or conversion, not on the date of the contribution or conversion.
When you decide a conversion wasn’t the right move, you can recharacterize the IRA (switch it back to a traditional IRA). After that, you can reconvert to a Roth IRA. But there are restrictions on the reconversion. The limit on reconversions can be confusing, and the rule has changed over the years.
The current rule limiting reconversions is that a reconversion can’t occur in the same calendar year as the recharacterization. Also, at least 30 days must pass between the recharacterization and reconversion.
Example. A converted Roth IRA is recharacterized as a traditional IRA on Dec. 15, 2010. The owner can’t reconvert until Jan. 15, 2011. He has to wait until the later of the next calendar year and 30 days before reconverting.
Example. A converted Roth IRA is recharacterized as a traditional IRA on July 1, 2010. The IRA can be reconverted on Jan. 1, 2011, because that is the later of 30 days and the next calendar year after the recharacterization.
Traditional IRAs with after-tax, or nondeductible contributions, present interesting issues.
The basic rule is when an IRA has both pre-tax and after-tax contributions, the after-tax contributions are tax-free when converted to the Roth IRA. Suppose want to convert only a portion of an IRA that has after-tax contributions. You can’t convert only the after-tax contributions or convert the after-tax contributions first. Instead, a pro rata portion of your converted amount is considered to be after-tax contributions.
Example. You have $100,000 in a traditional IRA, and $20,000 of it is after-tax contributions. One-fifth, of 20%, of the IRA is after-tax contributions. Whatever amount you convert, 20% is not taxable and 80% is included in gross income.
Consider this strategy. First, you roll over the after-tax contributions to a separate IRA, leaving only after-tax contributions in the IRA. You convert the IRA that contains only the after-tax contributions to a Roth IRA, making the rollover tax-free and all future distributions tax-free. You leave alone the traditional IRA with the pre-tax contributions and earnings and gains. There’s nothing explicit about it in the law. I understand Fidelity Investments has told people the strategy is allowed. I haven’t seen anything official from the IRS on it, and the law isn’t crystal clear.
There also are a couple of tricks to the computation of the after-tax percentage. When you compute the tax-free part of the conversion, the formula is to take the total basis (or after-tax contributions) of all your IRAs and divide it by the total value of all your IRAs. Also, the total value of all your IRAs is determined on Dec. 31 of the year of the conversion.
These rules mean you don’t know exactly the tax-free portion of your converted amount (if you don’t convert all your IRAs) until after the end of the year. It also means transactions you make during the year can affect the tax-free amount. For example, suppose you convert an IRA in June. Later in the year you decide to retire or switch jobs and roll over the balance of your 401(k) plan into an IRA. This increases balance of all your IRAs as of Dec. 31 and decreases the tax-free amount of the earlier conversion. This is something you have consider when you might roll over an employer plan balance to an IRA during a year when a conversion was made.
Inherited IRAs can’t be converted to Roth IRAs. That’s the rule, so heirs are stuck with a traditional IRA unless the original owner converted during his lifetime.
When an IRA owner is over age 70½, required minimum distributions must be taken from IRAs. That rule was suspended in 2009 but is back. You must take an RMD for the year of the conversion no matter when during the year you did the conversion. That means be sure to take the RMD before the conversion or leave enough money in the traditional IRA to take the RMD before Dec. 31.
Some people ask about the mechanics of conversion and recharacterization. These actions are taken through the IRA custodian. In most cases you simply fill out a form, either on paper or online, saying how much you want to convert. If you convert an entire IRA, the custodian simply redesignates it as a Roth IRA. If you convert a specific amount, the custodian creates a Roth IRA and transfers that amount of assets to it. A recharacterization is the reverse procedure.
May 2010. RW
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