More Lowdown on Roth IRA Conversions

The Roth IRA conversion opportunity is getting closer. Last month we discussed the basics of the opportunity and who should consider taking advantage of it. We continue the discussion in this visit with more details about the rules and ways you can enhance the benefits. 

To review from last month, next year the income limit is removed for converting a traditional IRA to a Roth IRA. In addition, for conversions done in 2010 you can choose to pay the tax bill in 2010 or defer it in equal installments to 2011 and 2012.

If you defer the taxes to 2011 and 2012, you include equal amounts of the converted amount in gross income each year. You pay income taxes at the rates that prevail in 2011 and 2012. That is one factor that complicates the decision to defer. The climate in Washington indicates that tax rates are likely to rise, at least for higher incomes, after 2010. That could make deferral more expensive than paying the taxes in 2010. We hope Congress will take any action on income taxes in 2010, so we will have a firm idea of the costs or benefits of electing the deferral.

The Waiting Period

The five-year waiting period causes some confusion, because the rules are confusing. 

For a distribution from a Roth IRA to be tax-free, it must be made after the later of the owner’s turning age 59½ and when the owner has had the Roth IRA for at least five years. For distributions from regular Roth IRAs, the five-year period for all regular Roth IRAs of the owner is met if any Roth IRA of the owner has been opened more than five years. 

For converted Roth IRAs, however, there is a separate five-year period for each conversion. If you converted a traditional IRA to a Roth IRA in 2010, you have to wait five years before taking the first tax-free distribution, even if you are over 59½ and had a regular Roth IRA more than five years.

But wait, there’s more. Roth IRAs have “ordering rules.” Distributions of less than the entire IRA are assumed to be taken in a certain order. First distributed are regular contributions. Distributions of converted amounts are next. Only after regular and conversion contributions are distributed are earnings distributed. The ordering rules are important, because only distributions of earnings are taxed. Distributions of regular and conversion contributions are not taxed. So, if you are over age 59½ and convert a Roth IRA in 2010, only a distribution that exceeds your converted amount is included in gross income. Even if you are under 59½, you avoid taxes on a distribution until your entire converted amount is distributed.

As we also discussed last month, the 10% early distribution does not have the ordering rules. If you are under age 59½, you may owe the early distribution penalty on a distribution that is not included in gross income.

Account Types & Computing Taxes

Conversions to a Roth IRA are not limited to traditional IRAs. In 2008 and for later years, any retirement plan distribution that is eligible for a rollover to a traditional IRA can be converted into a Roth IRA by a direct rollover. If you can do a rollover from your 401(k) to a traditional IRA, then you can do the rollover to a Roth IRA. You’ll include the rollover amount in gross income as with a conversion and otherwise treat it the same as a conversion of a traditional IRA to a Roth IRA. (There’s a caveat for those with Simple IRAs. Those accounts must be held for at least two years from the date they were first established before they can be converted to Roth IRAs.)

When you convert an account to a Roth IRA, nondeductible contributions are not included in gross income. You already paid taxes on them. Only previously untaxed amounts (such as deductible contributions and amounts excluded from income, such as 401(k) contributions) and account earnings are included in gross income. The rest of the account can be converted to a Roth IRA without incurring a tax bill.

You have to keep track of your total nondeductible contributions over the years to avoid paying taxes on money you don’t need to. If you don’t have the proper records, you can ask your IRA custodian for help, or you can buy copies of your past tax returns by filing Form 4506 with the IRS.

Suppose you have several IRAs. One has a lot of nondeductible contributions and the other primarily has only amounts that would be taxed if converted. You might be thinking you should convert only the IRA with nondeductible contributions, because there wouldn’t be much of a tax bill.

The IRS won’t allow that. It has a pro rata rule that requires you to take the balances of all your IRAs and divide them into the nondeductible contributions. The result is your excludable percentage. If you convert only some of your IRAs during the year, you exclude that percentage from gross income, regardless of which IRAs are converted.

Losses & Conversion Costs

Some people have net losses in one or more of their IRAs because of the bear market. They want to convert these traditional IRAs to Roths, not include any of the converted amounts in gross income, and deduct their losses.

The rules are not that simple. Any converted amount attributable to deductible contributions or investment earnings is included in gross income, even if it is less than what you initially put in. Only nondeductible contributions are not taxed, using the pro rata rule just discussed.

You might be able to deduct losses in your IRAs, but there are high hurdles. The value today must be less than your “tax basis.” Only nondeductible contributions are included in the tax basis. So, if you convert an IRA that contains only nondeductible contributions and the value is less than the total contributions, you have a net loss that can be deducted. But it can be deducted only as a miscellaneous itemized deduction on Schedule A, not as an investment or capital loss.

The hurdle is higher if you have more than one IRA, including Simplified Employee Pensions and Simple IRAs. You must convert all of the accounts, and the total value of all of them must be less than their total basis. Few people will be able to deduct losses on their IRAs.

There might be an additional tax costs in the year of conversion. Some deductions or other tax breaks are limited when your adjusted gross income exceeds certain levels. Social Security benefits and some other types of income are taxable when AGI exceeds certain levels. When an IRA is converted, the amount included in gross income can trigger some or all of these adverse tax consequences. This is true whether you pay the taxes in 2010 or spread them over 2011 and 2012.

This is a cost to be considered when deciding whether to convert, but remember it applies only to the years converted amounts are included in income. Also, you have the reverse effect after the conversion. Distributions from a traditional IRA that would have increased AGI are not included in AGI when they come from a Roth IRA.

States Taxes, Changing Rates & More

Be sure to check your state’s tax rules before doing a conversion. Many states follow the federal rules. Others do not. A state that does not follow the ordering rules discussed earlier could tax Roth IRA distributions that are tax free on your federal return. A few states do not recognize Roth IRAs and fully tax distributions from them.

Try to realistically consider what your tax rate will be in retirement when doing estimates. A substantial drop in your tax rate might defeat the benefits of conversion, but the tax rate reduction probably must be very large for it to offset the advantages of a Roth.

Don’t forget about estimated taxes. A conversion increases your tax bill for the year. To avoid an underpayment penalty, you must prepay enough taxes through either withholding or estimated tax payments. We discussed these rules in detail in past visits, and you can find them in the Archive on the web site.

A conversion does not have to be of a complete IRA or all your IRAs. You can convert as much or as little of your IRA assets as you want. You can determine the amount of the conversion by deciding how much cash you have available to pay the taxes. Or you can decide to convert only enough to keep from being pushed into the next higher tax bracket. You can convert in installments over as many years as you want.

When converting, a smart move might be to convert one traditional IRA into multiple Roth IRAs. Open a separate Roth IRA for each different type of investment in the traditional IRA.

Here’s why. If an asset declines in value, you can reverse the conversion. You don’t want to pay income taxes based on an IRA’s value on the day of the conversion if it has declined in value. You can reverse the conversion and do another conversion at the lower value, after a waiting period. (We have more details on reversing conversions in the web site Archive and will update them in a future visit.)

When a conversion is into only one Roth IRA, the net return of the portfolio determines whether there is a decline in value. If one asset declined in value while another rose, there is no net change and no point in reversing the conversion. If each asset is in a separate Roth IRA, you can reverse those that declined in value and keep the others. (Not all IRA sponsors will allow you to set up multiple Roth IRAs. You might have to change custodians or set up IRAs at different custodians.) After the period to reverse a conversion expires, you can move all the assets back into one Roth IRA.

Last month we listed several web sites with calculators. Another good calculator to consider is at www.bankrate.com.

RW November 2009.