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Consequences of a Large Roth IRA Conversion

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Retirement Nest EggsYou won’t have a bigger fan of a Roth IRA. I’ve been a fan of them every since my dad told me about them over ten years ago. Back then, the appeal was in not having to keep track of capital gains and losses for tax purposes. As a kid with little understanding of personal finances and a healthy appreciation for the law, that seemed paramount. Nowadays, it’s the tax free investing that appeals to me and every other fan of the Taxpayr Relief Act of 1997.

The Roth IRA conversion income limits were removed this year and mainstream media pounced all over the topic of Roth IRA conversions. Until this year, you could convert if you earned less than $100,000, but this was the year the floodgates were opened. It seems like a no brainer, but there are significant and immediate consequences to converting a large amount into a Roth IRA. The allure of tax free investing and accrual is very strong, but there are many considerations many experts are overlooking.

At the core of these consequences is your income. Roth IRA conversions have a funny way of increasing your income significantly, especially if you’re making a large conversion from an IRA you’ve accumulated for years. Even five or ten years of diligent saving can result in a boost you are likely unprepared for. While it’s straightforward to calculate how much additional taxes you’ll owe, that’s simple math, it’s harder to see all the consequences of a much higher income.

All of these consequences are income based benefits you may lose as a result of higher income. Even if these don’t apply, hopefully they will get your brain on the right track so you can think of the benefits you might lose from having a higher income.

Roth IRA Contributions

When you convert a 401(k) or a Traditional IRA into a Roth IRA, it doesn’t count as a contribution for the purposes of the Roth IRA contribution limit. It does, however, increase your income and subject you to the IRA contribution phaseouts, which you can calculate using our handy Roth IRA contribution phaseout calculator. By making a conversion, you may preclude yourself from making a Roth IRA contribution this year.

First Time Homebuyer Credit

Did you take advantage of the first time homebuyer credit and get some help on the down payment? If so, you need to be aware that there are income limits of $125,000 for single filers and $225,000 for married filing jointly. After that, there is a phaseout range where you would only be eligible for a partial credit. If your IRA conversion bumps your income above that limit for 2010, you will become ineligible for the credit.

I don’t know what penalties you’d have to pay but you at a minimum you would be required to repay the $8,000 credit or the phased out portion.

Financial Aid

When you convert, your tax return will show that you have a large influx of income and that will likely have an impact on your financial aid. It makes logical sense, if you made more money, then you will require less aid. However since this isn’t really income, it’s just a tax move, it’s important that you contact your child’s school to explain the large increase. They will take that into consideration and while it’s no guarantee they will discount the conversion, it’s better than not calling and explaining.

If you are done with school but not yet done with student loans, a higher income could reduce the deductibility of the student loan interest. The phaseout for single filers is $55,000 to $70,000 and for married filing jointly, it’s $115,000 to $145,000. You can deduct up to $2,500 in student loan interest each year, subject to the phaseout.

Itemized Deduction Phaseout

This phaseout no longer applies for 2010 but could make a return if it’s reinstated. If you earn more than $166,800 (or $83,400 for married filing separately), you could see your itemized deductions phased out. It is reduced by a third of the lesser:

  • 3% of your AGI above $166,800, or,
  • 80% of the total itemized deductions.

This is best explained with an example, so let’s say you earned $200,000 and had $20,000 in itemized deductions.

  • 3% of your AGI above $166,800 is $996
  • 80% of your total itemized deductions is $16000.

$996 is clearly smaller, so you divide that by 3 to get $332 and that is phased out of your $20,000 in itemized deductions.

First, it doesn’t apply to 2010 because it expired in 2009. With budget shortfalls, it might make a comeback. Also, it may or may not be significant, depending on the amount of your conversion. It has been in effect from 2006 to 2009, so having it return is not unprecedented.

Hopefully, these few examples will give you a good direction to start thinking about your own financial situation. If you have any examples of consequences that I missed, please share them in the comments!

(Photo: scottwills)

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12 Responses to “Consequences of a Large Roth IRA Conversion”

  1. I am from Canada and don’t know too much about Roth IRA’s but I know that ther are similar to RRSP’s here in Canada.

    Since there is a limit with which you can contribute and get the tax savings it would seem prudent to stay within that limit to save the taxes.

    Seems like most of the consequences that you have listed would be the same with an RRSP.

    Cheers!

    Brandon

  2. cubiclegeoff says:

    I converted, but I had less than $10,000 to convert so it won’t change my income enough to make a difference.

  3. cdiver says:

    Can you choose to reconvert back to your IRA if the consequences end up being too high as long as it is by April 15, 2011?

    • Jim says:

      Reconverting is somewhat of a pain but it is still possible, it’s called a re-characterization and I recommend talking to a professional about it. :)

  4. zapeta says:

    I didn’t think about the potential consequences other than having to pay the tax on the money converted. I wanted to convert an old IRA to a Roth this year but I don’t have the money to make the tax payment and I’m not going to take it out of the IRA to pay the taxes. I figure that having both a traditional IRA and a Roth IRA helps hedge against tax changes in the future.

  5. billsnider says:

    The latest issue of Money Magazine has some thoughts on this subject.

    Bill Snider

  6. Jeff Rose says:

    Good post and impeccable timing. I just talked to a guy today that was considering the Roth conversion, but he was concerned about the FAFSA, as his daughter is getting ready to start college soon.

    JoeTaxpayer had a good write up on the unforeseen consequences of the Roth IRA conversion here: http://www.goodfinancialcents.com/roth-ira-conversion-pros-cons-unforeseen-consequences/.

    He addressed a few topics that weren’t mentioned here such as if you own employer (company) stock in your retirement plan. If so, you may be subject to NUA (Net Unrealized Appreciation). The gist is that you’ll pay more tax than you should have if you do the conversion.

    The conversion doesn’t make sense for everybody. I’ve actually done few conversions than I thought I would. Most people don’t want to fork over the cash to pay the tax today. If you’re considering it, as Jim said, talked to a professional.

  7. eric says:

    I think this is one of those times where consulting a professional like a CPA is definitely worth it. There are a lot of good but also “bad” things that could result when you convert and everyone should know about all of the consequences before pulling the trigger.

  8. jsbrendog says:

    this is oen thing I am not looking forward to whenever I move on frmo my current company to greener pastures. the 401k conversion confuses me.

  9. Bobbie says:

    I will payback my Social Security benefits received since age 62, and resubmit my application as of 70 1/2 for a higher premium. I get a credit on the $19,000 worth of benefits that were subject to taxes. I figure that credit, will wipe out most of the tax due on converting close to $90,000 of IRA to a Roth.

    I have two question regarding this.

    1. Queries to the IRS assure me I get to apply all $19000 to the tax owed, but I worry that I’ll find out down the road that the IRS will only allow a credit of the TAX PAID on that $19000, which would be only be a credit of about $3000. What do you think?

    2. My financial advisor has already made the conversion according to my premature verbal instructions. I still do not have the go-ahead from Social Security though, and, if the payback and re-application is refused, I will have to undo the conversion. Is this possible? What is involved? Should I perhaps do this immediately or wait until I have an answer from SSI? It could be a matter of six weeks.


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