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)

{ 89 comments, please add your thoughts now! }

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89 Responses to “2010 Roth IRA Conversion Rules”

  1. DinFL says:

    For ROTH conversions in 2010, can I declare part of the conversion amount in 2010 and then split the balance between 2011 and 2012?

    • Jim says:

      You do the conversion in 2010 but you can opt to split the taxes across 2011 and 2012.

      • DinFL says:

        But can you split the conversion into three years, 2010 for a portion and then 2011 & 2012 for the balance? I suspect that you will be required to select one or the other (all in 2010 or a 2011/2012 split), but if the conversion can be allocated over three years it would save more taxes.

        • Matt says:

          You cannot split into three years. You must pay it all in 2010 or split it evenly between 2011 and 2012.

          • Cheap Bastard says:

            Ouch! Show stopper for me.

            Requiring the sum of all 401k accounts to be converted at once and declared all at once forces the conversion to happen in an absurdly high tax bracket. That’s no good.

            Who cares about distributing the tax after the damage is done? Rather than spreading out the copious damage, I’ll opt not to do the damage in the first place.

            Any tricks to get around this?

  2. Billsmy says:

    Jim, do you mean that the 2010 conversion could be made by paying no tax (on the conversion) on your 2010 tax form but by paying the tax on exactly half of the conversion on your 2011 tax form at the 2011 tax rates, and paying on the other half on your 2012 tax form at the 2012 tax rates? If so, could you alternatively split it between 2010 and 2011?

  3. Bob says:

    If you are going to to do a conversion from the traditional to the Roth and you are under 59 1/2, are you penalized the 10% early withdrawl penalty from the traditional IRA?

  4. Bill Marble says:

    I have 2 separate IRA’s: A traditional IRA that includes many years of nondeductible IRA contributions and a very large Rollever IRA that came from a closed down 401K Profit Sharing account. The funds in both accounts have always been kept separate. I only plan to convert the traditional IRA to a Roth IRA in 2010. I will leave the Rollover IRA untouched.
    Question: In caculating the taxable portion of the Roth conversion, can I simply deduct the nondeductible contributions from the total value on the date of conversion of the single traditional IRA. Someone told me they thought your were required to take into account the combined value of both IRA’s (including the large Rollover IRA that I am not converting) to calculate the ratio of pre-tax and after-tax dollars. This would result in a larger tax-hit on the traditional IRA.

  5. Cheap Bastard says:

    I discovered another nasty gotcha: 10% excise tax on top of the regular tax.

    That, combined with the fact that all funds must rollover together all the same year and therefore be taxed in a high bracket makes me wonder when it ever works out to be a good move for anyone.

  6. Chris says:

    Something that is never covered in these articles that I would like to know. I understand that the rollover amount counts as ordinary income, but when calculating your eligibility you do not count the conversion income, is that correct?

    I’m in a position where my AGI is under the limit on it’s own, but if I count the conversion amount I would be over the limit. My understanding is that is fine, but I’m not sure?

  7. psc says:

    stupid ??, but no one knows the answer, currently hold 66K in traditional IRA , lowest tax bracket now and at retirement, current age, 52 , does it make sense to convert to a roth, or make all new contributions to roth, or stay where i am and benefit from the tax break i now receive

    • Cheap Bastard says:

      Use this calculator to calculate whether the conversion is favorable:

      I’m not sure if that calculator is sophisticated enough to add the additional 10% excise tax. I suspect it’s not, because with a 10% extra tax, it generally does not make sense to do the conversion.

  8. Ira S Chorush says:

    I believe (but am not sure) that there is a way to convert from traditional to roth in 2010 and to spit the taxable income among the three years 2010, 2011, 2012. This should be possible if a married couple each intends to do a conversion. Can the wife elect to have her conversion taxed in 2011 and 2012 and the husband elect to have his conversion taxed in 2010?

  9. len says:

    With current government legislation I anticipate that personal income tax rates will be raised in 2010. Since you are permitted 60 days to roll over a traditional ira to a traditional Ira, would it be possible to withdraw funds from a tradtional IRA in 2009. Pay the ordinary income tax rates in force in 2009 and then before the 60 days is up roll the funds into a Roth IRA. avoiding 2010/11/12 increased tax rates

  10. Val says:

    I must take the Required Minimum Distribution(RMD)from my traditional IRA in 2010. Can I rollover the RMD amount into my Roth IRA and pay the tax in 2011 and 2012 or can I take more than the RMD amount and pay taxes on the overage amount in 2011 and 2012 and the RMD portion in 2010?

  11. Adam says:

    I want to convert my wife’s and my non deductible traditional IRA’s. My wife has $32,000 in gains but I have $5,300 in losses. Will the gain and loss offset? We file married joint. Thank you.

  12. Starr J says:

    Regarding your idea that placing stock in your IRA is smart because the gains are tax free:
    Let’s take a look at how owning stock works if you hold it outside your box:
    • One of the advantages of owning stock is that you don’t have to pay taxes on the gain until you sell it
    • So as long as you own the stock it can gain and gain forever and you don’t pay taxes on that gain until you sell it and get your money.
    • Well, that’s the same thing… It’s already tax deferred
    Here’s the real kicker – Capital gains are generally taxed at a much lower rate in comparison to ordinary income. So the tax that you pay on that stock you hold outside of your IRA is typically much lower than the tax that you ultimately have to pay on the money inside your IRA.

  13. Chandan Dutta says:

    I did exactly what you said. I have a traditional IRA where most of the money is after tax. In 2009, I converted my pre-tax 401K to a Rollover IRA and kept is separate from the traditional IRA. Now I find that whatever I convert will be pro-rated based on the total IRA.

  14. Andy says:

    A few questions reguarding a 2010 conversion from Regular IRA/401K to a Roth IRA. I file a joint federal return. When do you need to declare that you are deferring taxes into 2011 and 2012? Can my wife do a conversion and pay the taxes in 2010 and can I do a conversion and defer into 2011 and 2012, in order to spread the overall tax burde into three years?

  15. Daniel Seifring says:

    Question, if I convert my non deductible IRA to a Roth IRA this year. How do I handle this with regards to the IRA not taxing me? My Custodian (American Funds) will report this since they do not title my account Non Deductible IRA.

  16. Meagan says:

    Great article. If you earn too much to contribute to a Roth IRA, what stops you every year going forward from rolling your 401-k to a Traditional IRA and then immediately converting that amount to a Roth IRA? Depending on how much your employer matches, it seems like you could potentially contribute much more than $5,000 per year to your Roth IRA if you wanted to.

  17. Fletch says:

    I converted a portion of a SEP IRA into a Roth earlier this year. All the positions transferred were call options ($54,000) and one of the calls expired worthless (original value at time of Roth conversion was about $10,000). I called my broker to “reverse” the conversion of that security and they are unable to do so since it expired worthless and technically it no longer exists. I don’t want to pay taxes on the $10,000 – how do I handle this for tax purposes?

  18. Roseann says:

    I was told tonight that if I took Traditional IRA money and converted it to a Roth IRA invested specifically in oil and gas drilling, I would not have to pay taxes on the non-taxed Traditional IRA money. Could this be possible?

  19. Ryan says:

    I know that Roth contributions can be made until April of the following year to be included in the present year. (Contributions through April 2011 can be considered 2010 contributions)Do the same rules apply for roth rollovers (IRA to roth rollovers)?

  20. Marie says:

    I have $10,593. in a ROTH, can I add any amount to it and not have to pay taxes on it for 2010.
    I already paid the taxes in 2009 on the amount in my ROTH.

  21. a reader says:

    Can you elaborate further on a non-deductable IRA that has a loss in it. Can this loss lower tax liability like any other loss in a stock for example?

  22. Euphemia Corcoran says:

    I have four traditional IRA accounts – I have to take the RMD yearly. Can I take one of the IRA accounts and convert it to a Roth IRA in 2010 or does it have to be all four IRA accounts that must be converted to a Roth at the same time or a percentage of each. I only want to convert one of the IRA accounts.

  23. Jacquelyn says:

    I have a 401k from a job I left 9 years ago. I never rolled it over under my current employer. In order for me to convert it to a Roth IRA, I must roll it over to a traditional IRA? In doing so, do I have to pay tax on the amount as ordinary income? Your response would be greatly appreciated?

  24. Billyboy says:

    I am considering taking $250K from my 401K and rolling it into an IRA (60 years old). $33k of this is after tax dollars. Can I selectively convert the $33k into a Roth without incurring any additional tax on the conversion? Or would I have to prorate the $33k vs the new total IRA dollars created by the withdrawal? I have a pretax IRA worth about $6k in addition to my 401K.

    Would I be better off only withdrawing the after tax portion of the 401k (that is the 1st portion distributed)and doing the conversion, then later in the year rolling over the remainder of the $250K?

  25. beachcrawler says:

    I lost almost all of my contributions to my Roth when the tech bubble busted. Since then I have rolled over a 401k plan to an IRA and now converted it to the Roth. After 5 years can I withdraw my original contribution tax free even though that money was lost long ago?

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