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2010 Roth IRA Conversion Rules

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2010A year ago, when I met with my accountant, we spent some time talking about our retirement, our goals, and how we were going to reach them. In looking at our retirement accounts, I saw that the vast majority of our savings were in tax-deferred accounts like 401(k)s and Rollover IRAs. We only had a very small percentage in tax-free Roth IRA accounts, which I’ve always said was probably the best retirement account in existence. Where else can you invest in the stock market and have your gains be entirely tax free? Nowhere. :)

Right now, you can convert a traditional IRA to a Roth IRA as long as your adjusted gross income is under $100,000. The $100,000 limit applies whether you are single or married, tax filing classification wise, which makes it one of the few limits that is the same for both. So if your AGI is under $100,000, then you can convert today and you don’t have to wait for 2010.

Do You Want To Do This?

Before we get into the mechanics and the rules, you have to ask yourself whether you want to do this. The benefit of converting is that your assets can now grow tax free. With a typical Roth IRA, you don’t deduct the contributions from your taxes so you gain no immediate tax benefit. The tax benefit comes on the tail end when distributions from that Roth IRA are tax free. With a traditional IRA, you gain an immediate tax benefit because you can deduct your contributions but distributions are taxed many years later as ordinary income.

We have two major decisions during the conversion process:

  1. Tax diversification: Since we won’t know the tax rates, or how tax will be collected (more income taxes? more sales taxes? VAT?), it’s difficult to say which type of account is better. The basic decision is that if you think your tax bracket will be higher when you draw from the account, then you want a Roth IRA. I’m of the belief that you should diversify between tax benefits today and tax benefits tomorrow, so I want to convert a few of my accounts over so I get a more even mix.
  2. Paying the tax today: When you convert a Traditional to a Roth, you have to pay taxes on that conversion. I’ll go into greater detail on this but the gist is that you will need to claim the conversion amount as ordinary income and pay taxes on it. There are opportunities to defer on a limited basis but you still have to come up with the funds somehow.

Now that we have a good idea of the big decision points, let’s get into the mechanics.

$100,000 AGI Rule Removed

2010 is such a big deal because the $100,000 AGI rule is lifted, making a conversion possible for many dual-income families. According to the Journal of Financial Planning, it’s believed that more that 13 million people will become eligible for a Roth conversion when the limit is lifted.

Conversion Tax Rules & Implications

When you claim the ordinary income and pay taxes: Normally, when you make a conversion, you must claim the conversion amount as income the following year. If you convert in 2009, it is considered ordinary income for 2009 and taxes are due April 15th, 2010. However, there’s a special rule for conversions made in 2010, you can opt to recognize half the conversion amount as ordinary income in 2011 and the other half in 2012 (or recognize it in 2010). This special rule is only for conversions in 2010. If you convert in 2011 and beyond, the normal rules apply.

Experts advise that you should only convert if you can pay the taxes with other funds.. You also have the option of paying for the taxes from the account itself but every expert I’ve read recommends against that. If you want your money to grow tax-free, it’s best to maximize how much it can grow. If you’re planning on making a conversion, start saving for the taxes today.

Recognizing the conversion amount as ordinary income can cause problems. This is an issue many people overlook. When you convert, you have to recognize the conversion amount as ordinary income. This can have a significant effect on your finances. You may become ineligible for certain deductions or credits because of their income phase-out requirements so be sure to take this into account.

Non-Deductible Traditional IRA Loophole

One big consequence of lifting the AGI limit is that it creates a loophole for high income earners shut out of the Roth IRA. In general, if your employer offers a 401(k) or other defined contribution plan, you can’t deduct your contributions to a Traditional IRA. If you also earn too much, then you can’t contribute to a Roth IRA – leaving you with one less valuable option: a nondeductible Traditional IRA. It’s less valuable because you don’t get to deduct your contributions and your growth is taxed when you withdraw the funds in retirement. (Thanks Dan!)

In 2010, with the $100,000 AGI limit removed, you will be able to convert a nondeductible Traditional IRA into a Roth IRA without paying a penny. Since you’ve already paid the taxes, you won’t have to pay them again to convert it into a Roth. This loophole lets high earners “contribute” to a Roth IRA.

The one thing you have to look out for, which my accountant warned, was that you need to segregate your nondeductible Traditional IRA from your other IRAs. If you make a nondeductible contribution into a regular Traditional IRA, where you’ve taken deductions, then it muddies the water and causes issues. So if you want to use this tactic, make sure it’s segregated into its own account. It just makes everything easier for you down the road.

How to Convert

While it’s called a conversion, you’re actually rolling it over from a traditional IRA to a Roth IRA. The process will be similar to when you rollover any type of account, such as a 401(k) to a Rollover IRA. Since you would usually roll the assets over without changing brokers, the process may be as simple as filling out a form. Your best option is to contact your broker and find out what you need to do.

I believe I covered all of the rules and tried to give you a little insight into how I’m making the decision. The hardest part about all this is that the future is unclear. If there’s something I’m missing, let me know and I’ll add it to the post.

(Photo: doug88888)

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89 Responses to “2010 Roth IRA Conversion Rules”

  1. AmandaDRowe says:

    Hi Jim -

    Great Post. I wanted to ask about converting 401k’s to a Roth. If I were to do this, will this count towards my $5k per year max? Any thoughts would be appreciated!

    Thanks!

    • Jim says:

      Conversions are not part of the contribution limit. The $5k is how much you can contribute directly into a Roth. If you convert a Traditional IRA to a Roth IRA, it doesn’t count towards that limit.

      • Christine says:

        You can only convert the 401k to a roth if there is a separation of service from your employer (laid off, fired, quit, or are over age 59.5).

  2. Chris says:

    Does anyone know if you can convert a 401K into a Roth 401K under the same guidelines?
    Thank you.

    • Jim says:

      No I don’t think you can, i believe you would have to convert the 401K into a Rollover IRA and then convert it to a Roth IRA.

      • Chandan Dutta says:

        You can directly convert 401K to Roth IRA. You will owe taxes on all the pre tax contribution and all the gains.

        You may also be able to convert only after-tax 401k to Roth IRA and avoid any taxes.

        You can only do it after you leave the company or if you are 59 1/2 Years. There is an article “A Sweet Deal on Roth IRA Conversion” by Mary Beth Franklin in the January 2009 publication of Kiplinger’s Personal Finance Magazine.

  3. Mandy says:

    Wait, Jim, this part isn’t quite correct: “In general, if your employer offers a 401(k) or other defined contribution plan, you can’t deduct your contributions to a Traditional IRA.” This is only true if you meet the income limits. Those who have 55K and under single and 89K and under jointly have full deductibility with a traditional IRA, even with a qualified employer plan. You’ve got a lot of readers on both sides of the deductibility limits, so I would be cautious about making such a generalization.

  4. zapeta says:

    Thank you for collecting all of the info in one place! I have a 401k that I anticipate rolling to a traditional IRA in the next year and I will probably do the 2010 traditional to roth conversion to spread the taxes across two years.

  5. matk54 says:

    great information – thanks.

  6. Franco says:

    I used this research paper from Vanguard to help me decide what to do.

    PDF link

  7. Brad says:

    Great post! I have been considering converting lately, and you have helped to clarify things.

    Right now, we have two traditional IRA’s and two Roth IRA’s between my wife and I. Plus I have a 401K plan. It is a nightmare to balance my portfolio across so many plans, especially when some of them have smaller balances.

    While you bring up a good point about tax diversification, I am going to start converting my traditional IRA’s to Roth’s. This should help to simplify my annual rebalance efforts while taking advantage of the Roth benefits. I also like the thought that my out of pocket tax bill will be much lower now than later as the balance (hopefully) grows.

    It will take a couple of years due to the amount of taxes, but in the end I think it will be worth it.

  8. Ari Weinberg says:

    If you convert a non-deductible, you still have to pay taxes on the gains.

    • Lydia Hsieh says:

      My non-deductible suffered a $7000 loss last year. Do you or Jim know how to report this loss when I convert it into my existing Roth account that I created years ago. Thanks a lot for your help.

      • Jim says:

        In general, if it’s in an IRA then you can’t deduct the loss. There are exceptions but they include withdrawing all of your money from all of your IRAs (which it doesn’t sound like you want to do). Here’s more info on that if you want to know what I mean.

  9. JG says:

    When converting to Roth IRA and reporting it as ordinary income do you have to pay Federal, State, local and Social Security taxes or is it just Federal taxes?

    • Jim says:

      You have to pay them all since it’s treated as ordinary income, which is taxed by all four (and Medicare).

      • Daniel says:

        This doesn’t make sense. When you contributed to the IRA (or employer sponsored 401(k) and then rolled it over to a Rollover IRA) you payed the SS and Medicare taxes on that money. So you shouldn’t be taxed on it again. Just like you wouldn’t pay taxes on it at retirement.

      • KB says:

        You do not pay Social Security or Medicare tax on conversions. You have already paid them.

  10. I don’t think that the non-deductible IRA contribution is worthless. The gains grow tax free i.e. if you buy and sell, you don’t pay capital gains.

    • Jim says:

      You don’t pay capital gains when you buy and sell, but you pay ordinary income (short term capital gains is taxed at your marginal tax rate) whenever you withdraw the money in retirement. You are still double taxed, once on contributions and once when withdrawn. Your money grows tax free but you are still taxed on gains in retirement.

      • Dan says:

        I believe you are mistaken. As long as you file the appropriate paperwork during tax time for your non-deductible IRA contribution, you will not be taxed on that amount when you withdraw the principal down the road. The only sticky point is, they take a ration of deductible contributions to non-deductible contributions across all of your IRA accounts.

        I am almost certain of this because I have done a lot of research on the topic since I am in this situation myself. Do you have a source for your information so we can cross-check the facts.

        Here is a blurb detailing how non-deductible principal is not tax upon withdrawal from an IRA:

        “When you take your regular IRA distributions during retirement, you’ll pay tax on the growth. However, any non-deductible contributions are considered basis and, since you effectively paid tax on the money when you made the contribution, you won’t have to pay tax on it again later.”

        Source: http://retireplan.about.com/od/iras/a/non_deductible_ira.htm

        • Jim says:

          Dan, the more I think about it, the more I believe you are correct. Unfortunately I don’t have a source, it’s just something I’ve “known.” It makes sense that the principal is not taxed but the growth is.

          • Dan says:

            Cool. Now if we want to talk about double taxation, then I have an example for you.

            No one can explain to me why it’s okay for me to be charged personal property taxes and real estate taxes by both my county, Loudoun, and my town, Leesburg. Urgh!

  11. Bob IRA says:

    Can anyone help? If I rollover traditional IRA money to ROTH IRA in December of 2009, it is taxable income on the 2010 tax return. If I do the rollover in January 2010, do I get the grace period until April 15 for IRA contributions? I would like the income to be included on the 2009 tax return.

    • Jeff Rose says:

      If I rollover traditional IRA money to ROTH IRA in December of 2009, it is taxable income on the 2010 tax return?

      Yes

      If I do the rollover in January 2010, do I get the grace period until April 15 for IRA contributions?

      Yes, you will still be able to make a contribution for the 2009 tax year.

      If you want the income included for your 2009 taxes, you must do the conversion before Dec 31st.

  12. Jim,

    Great overview of the 2010 Roth IRA conversion process, just one issue.

    You write:

    “The one thing you have to look out for, which my accountant warned, was that you need to segregate your nondeductible Traditional IRA from your other IRAs. If you make a nondeductible contribution into a regular Traditional IRA, where you’ve taken deductions, then it muddies the water and causes issues. So if you want to use this tactic, make sure it’s segregated into its own account. It just makes everything easier for you down the road.”

    This isn’t necessarily true.

    In the eyes of the IRS, you only have one IRA, regardless of how many open brokerage accounts you use to host that IRA. While a segregated account might make it easier to personally differentiate between deductible and non-deductible contributions, it won’t make a bit of difference in regard to the taxes owed on a conversion.

    For instance, let’s say you have $5,000 of tax deductible contributions in an already existing IRA. If you earn too much to contribute to a Roth IRA this year, you can decide to make $5,000 worth of non-deductible IRA contributions and then convert those contributions into a Roth IRA (which would be tax-free since the original contributions were non-tax deductible).

    However, this is where things get muddy. In the eyes of the IRS, you now have $10,000 in your Traditional IRA (regardless of whether or not those funds are in different brokerage accounts). 50% is comprised of non-deductible contributions, while 50% is comprised of deductible contributions.

    If you convert $5,000 from your Traditional IRA to your Roth IRA, you can NOT selectively choose to only convert the $5,000 in non-deductible contributions. The conversion must take place on a percentage basis. So $2,500 of your conversion would be tax-free, while the other $2,500 is subject to taxes upon conversion. You then get left with $5,000 in your Traditional IRA with 50% in non-deductible contributions and 50% in deductible contributions.

    So while making a contribution to a new brokerage account might be of benefit to your personal record keeping, it won’t help at all when it comes to paying income taxes on any converted funds. I address this often misunderstood topic in the article “Multiple Roth IRA Accounts: Can You Have Them?”

    http://www.your-roth-ira.com/multiple-roth-ira-accounts.html

    In respect to this article, the same rules that apply to Roth IRA accounts also apply to Traditional IRA accounts. I hope this helps anyone who might be confused, and thanks for writing such a helpful article!

    Britt

    • Michael says:

      Please help me decide what the tax difference would be on the following:

      I plan to convert some money to a Roth in 2010 when I become eligible

      Currenty I have:

      10,000 in a deductable account
      14,000 in nondeductable account

      What is the tax I will pay on the conversion if my Federal and State Tax rate combined is 31%?

      vs the following situation:

      My company was acquired 1 year ago and I currently have 2 401Ks. One for the old company and one for the new company. The old 401k must be converted to an IRA or to the new 401K by Nov 30th.

      If I convert this 401k balance (currently at $100,000) to a traditional IRA what will be the tax consequence if any if my intent is to keep this money in an IRA and only convert the 24,000 mentioned above to an Roth IRA.

      Is the taxes I pay more or the same on the $24,000. I am trying to determine if it is smarter in my situation to convert the $100,000 to the 401K or the IRA.

    • Jim Lippard says:

      My wife and I both had only nondeductible IRAs which we have planned to convert to Roth IRAs in 2010.

      Unfortunately, just this month my wife rolled over her 401K and Roth 401K into IRAs when her company discontinued its 401K plan.

      I take it that the fact that she now has a deductible rollover IRA means we can’t convert her nondeductible IRA into a Roth IRA without paying taxes on the percentage in the rollover IRA, and should consider converting the rollover as well? I don’t suppose rollovers are treated any differently from any other IRAs?

  13. eric says:

    Complicated for sure but thanks for breaking it down

  14. jeff says:

    Questions I’ve had regarding this.
    Is this a one year deal? Put another way, can I contribute to a non-deductible ira in 2011 and immediately convert it? I recognize tax law can change.

    Specifically, how our losses in a non-deductible account treated in the conversion to a roth ira in 2010? I think I’ve seen you can deduct it subject to a percentage floor (2/8 I can’t remember the number.) This may be the case for many people who have been planning for this 2010 rollover. My wife and I have been maxing out non-deductible IRA’s for awhile now and have losses with the market conditions as they are.

  15. ephy says:

    As usual fantastic job Jim!!! Could you or anyone else reading the post answer my query.

    I already have a roth IRA. I don’t have a traditional IRA. I don’t think I would be able to deduct the traditional IRA contributions. Does it make sense to open a non-deductible IRA and then convert it to a roth IRA? Can I do that despite already having a roth IRA that is maxed out for 2009?

    Thanking you in advance for your help/ suggestions.

    • Jeff Rose says:

      If your Roth is already maxed our for 2009, you will not be able to contribute to a non-deductible IRA. That is a good strategy though for those that their income limits phase them out from making Roth IRA contributions.

  16. bb says:

    The amount converted to a ROTH is subject to regular income tax in the “year of conversion” !!!… I believe you are mistaken when you posted ” When you claim the ordinary income and pay taxes: Normally, when you make a conversion, you must claim the conversion amount as income the following year. — The tax “due date” of Apri 15th will be in the following year.

  17. Daniel says:

    For those who qualify, do the contributions from a conversion to a Roth IRA qualify for the Retirement Saver’s Tax Credit?

    In other words, if I currently in a qualified low-income bracket (full-time graduate student), will I receive a refund for some of the taxes withheld during the conversion. The tax credit has never been claimed on current IRA funds previously.

  18. mikestreb says:

    Not really along the lines of Conversion, but last tax year I liquidated my Roth IRA for a loss and took the deduction on the loss. It is subject to 2% of your AGI, but if your Roth IRA is down enough, it may be worth it if a few things go in your favor.

    Why it worked for me:

    I only had about $6,000 in my Roth.
    My basis in it was just over $9,000.
    The loss was, we will call it $3,000 for ease of illustration.
    Say my AGI was $50,000 (again for ease of illustration – I wish my AGI was $50k).
    I itemized last year.

    How it works is you take your liquidation amount (you must liquidate the entire Roth or the IRS will disallow this) and subtract out your basis. This left me with -$3,000. You are allowed to deduct this as a miscellaneous itemized deduction. All miscellaneous itemized deductions are subject to a 2% floor. So you take 2% of my hypothetical $50k AGI = $1,000. So you take the loss less the disallowed 2% of AGI and you get $3k – $1k = $2,000. So you are left with a $2,000 deduction that flows through your Schedule A onto your 1040. If your AGI was $50k, that would put you in the 25% bracket. So you are saving 25% of $2,000 = $500 more in your pocket.

    So now you take your $6,000 and put it right back into a new Roth IRA (the limit for 2009 is $5,000 for individuals). You can put $5,000 in right away and the other $1,000 in the next year. Essentially you are in the same exact position you were, but you have an extra $500 in your pocket. There are a few drawbacks to this. You lose the ability to put more in (essentially you are wasting $6k of your contribution limit).

    You also have to make sure not to trigger a wash sale. Make sure you buy something substantially different (I went from American Funds Capital Word Growth Fund to a Vanguard S&P500 Index Fund) or wait 30 days after the sale to re-buy.

  19. Chris says:

    So much great info. Thanks all.

  20. AmandaDRowe says:

    Alright Jim, another question for you – Since I’ll be converting a large chunk of money, who would you go with? I have my Roth with ING because I like the $4 trades and their mutual funds but this is for small amounts. My 401K that I’m going to convert will have a far deal more. Typically, I hear Vanguard is the way to go. Your thoughts?

  21. BillSmy says:

    I keep reading about converting in 2010, and then paying in 2011,and 2012 at the then existing tax rates. That doesn’t seem to make sense. If you convert in 2010, then you should logically be able to pay the taxes on your conversion on your 2010 tax form and ’10 existing rates, which you pay in Apr. 2011. Is this not correct?

    Ok, what about WHEN you convert in 2010? If you convert on Jan. 1, 2010, with IRA stocks worth $50,000 causing a $14,000 tax, and they drop to be only $30,000 in Dec. ’01, you’ll wish you had converted in Dec. instead with only an $8400 tax. Is there any protection against this? Since you have until Apr. 2011 to specify your 2010 conversion, can you at that time say that the conversion was to be considered coplete on say Aug. 22,’10 at which the IRA had a minimum value?

  22. Cheap Bastard says:

    Is this conversion from 401k to Roth IRA possible in a year when income is zero?

    An accountant is telling me a Roth cannot be contributed to if there is no income during the year.

  23. Jim Brennan says:

    Question: Let’s say you have $1 million in rollover 401K’s and convert them to a Roth in 2010. If you defer the tax to 2011 and 2012, do you pay the tax rates in effect in 2011 and 2012? If so and given the Bush tax cuts are likely to expire in 2011, aren’t you better off paying the full tax in 2010? Also, since NJ has a surcharge on income over $1 million, could you defer the $1 million in income resulting from the Roth conversion to 2011 and 2012 for your NJ taxes and pay the full amount in 2010 on your federal taxes? Thanks.

    • Jim says:

      I believe you’re correct on everything with one exception. Whenever you decide to make the conversion and pay the taxes, your state and federal must match. So if you take it all in 2010, you pay the federal tax and the NJ tax with surcharge. Confirm with a tax expert but I believe that’s the case.

  24. Mike says:

    Jim, this year attempting to get a higher return on my money, I put some into an oil and gas drilling investment. They told me I would be considered an active participant and could write off 85% of any costs associated to drilling to my share against ordinary income.
    Since most can be written off in the first year, would this be the opportune time to switch Traditional IRA’s to a Roth as that would be considered ordinary income.

  25. Cheap Bastard says:

    Most of our 401k’s took a big hit over the past year. I think mine lost 1/3rd of its value.

    Presumably, when we convert it to a Roth, there’s no way to deduct that loss, is there?

    Would be nice to get a tax relief during the conversion considering the loss. Although I realize this money was never taxed in the first place, this “ordinary income” was salary income that lost value.


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