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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. kappy says:

    I understand that in 2010 traditional IRA rollovers to a Roth IRA must be reported either as income in 2010 or split 50/50 as income in 2011 and 2012. The choice of taxable year in which the income is reported must be the same for all of a taxpayer’s IRA conversions in 2010. I am 63 years old and retired. In 2010 I converted a traditional IRA to a Roth IRA with the intention of splitting the income over 2011 and 2012. In 2010, can I also convert a portion of my 401(k) to a Roth IRA but report the income in 2010, or am I restricted to the same choice I have made for my traditional IRA conversion?

  2. David says:

    In the beginning of 2010, I contributed 10k to my Roth IRA, 5,000 for 2009 and 5,000 for 2010. I realized now that my AGI will be too high in 2010 for Roth IRA contributions. If I had known this to begin with, I would have contributed to a non-deductible IRA and converted but since I have already opened the Roth IRA and put in 5,000, is there a way to recharacterize it twice (to non-deductible and then back to Roth)? Otherwise, how can I convince the IRS I contributed to a non-deductible IRA and then converted to Roth?

    Thanks.

  3. Ace says:

    Pretty much the same question as Kappy. I converted IRA’s into multiple ROTH IRA’s in 2010 (basically one for each stock type). I did that in case I needed to recharacterize, but I don’t need to do that. The question is can I pay tax on one ROTH in 2010, but spread the tax over 2011/12 on the other ROTH?

    • Patrick says:

      Same question as Ace and Kappy regarding multiple conversions. Has this been answered? I know that Turbo Tax does not provide a method for segregating the treatment–it simply asks once if you want to declare the income in 2010 or if you want to defer to the ‘split income’ option between ’11 and ’12.

  4. Diana says:

    It isn’t enough to have non-deductible IRA’s segregated into their own account. If you have both non-deductible and deductible IRA’s, you have to consider both of the accounts when you convert to a ROTH. Ex: I have $30,000 NON-deductible IRA’s that I wanted to convert to a ROTH this year. However, I have a ROLLOVER (pre-tax) IRA. Even though it is segregated into its own separate account with Vanguard, I have to consider it when setting up the ROTH. I would have to pay income taxes now on $26,000 of my pre-tax IRA just to change the NON-deductible $30,000 to a ROTH.

  5. Dan says:

    I opened non-deductible IRA’s for 2009 (in April of 2010) and 2010 and converted both to Roth IRA’s in 2010. When I converted them, the amounts didn’t exactly match (lost some $ in the few weeks that it took to convert to Roth). When I fill out form 8606, it looks as thought the amount that I am “short” in the Roth is still in a traditional IRA (it doesn’t give a box to declare how much was gained or lost in the 60 day period to convert) Any thoughts how to report this?

  6. Gwen says:

    I left my employer in February 2010. Do you know if I can convert my 401(k)to a ROTH IRA before the April 18, 2011 deadline, count the rollover toward my 2010 income, and pay the deferred taxes in 2011 and 2012?

  7. Joyce says:

    How do I split my Trad IRA withdraws from my conversion to Roth so I can claim income from Roth IRA in 2011/2012?

  8. janet says:

    I must take out 7,000 from my ira this year (age 73) Can I convert this to a roth. I do not need this income this year and our taxable income is around $6000 plus ss income a combined 23,000 . my husband has a pension (workmans comp ) non taxable (n.Y.) Our adjusted income the last two years has been around 13,000. Is it wise for this year and maybe in the future to take this withdrawal and put it into a roth . Then in case I do need it I will not be doubly taxed. Thank you.

  9. Liza says:

    I did exactly what you described in the “Non-Deductible Traditional IRA Loophole”. I started the investment into my non-deductible traditional IRA since 2006 when I learned about the 2010 new regulation. The headache is that my account doesn’t know how to fill out the 8606 form. It is a mess. I am still waiting for my account to fill my 2010 tax return. I think something is not right with 8606 form with the conversion.

  10. Joseph says:

    From what I have seen, there is supposed to be a Form 8608 to report the conversion and tax deferral, as well as elect out of paying the
    tax in 2010. As of now, there is no form on the IRS wbesite for this.
    Waiting for April 17th to release it???

  11. Abhay says:

    Can I contribute to non deductible traditional IRA before April, 17th, 2011 applicable for 2010 and convert to Roth IRA? or it needed to be done only in 2010 calendar year?

  12. Elle Woods says:

    Roth conversions are NOT classified as roll-overs. Roll-overs are only applicable to same-IRA type transfers.


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