You 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.
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 )