2010 Provides a unique opportunity for IRA owners.
In 2010, you have the opportunity to convert your traditional IRA to a Roth IRA. The usual income limitations that stand in the way for converting will not apply. So, should you convert? Let’s look at why this may or may not be a good idea.
Here’s why a Roth IRA conversion may make sense for you
Consider this: a Roth IRA allows tax-free growth and tax-free income distributions at age 59½ or older and as long as you have held your Roth account for 5 years or longer. While your contributions to a Roth IRA do not allow a tax-deduction, the younger you are, the longer time frame you have for tax-free growth.
Now realize converting to a Roth IRA comes with a price tag. You will have to pay ordinary income taxes on the amount you convert. Whatever amount is converted is added to your income for the year. However, there may be a silver lining: With the market being down, most likely your account value may be the lowest it has been in years. This means by converting now you may pay lower taxes.
It is also worth noting that with all of the reckless government spending, there is a great chance that tax rates could increase in the years ahead. This is another reason why now may be as good time as ever to convert. If converting may send you into a higher tax bracket, you could consider doing a partial conversion (only converting a portion of your Traditional IRA to avoid going into the next bracket).
Even if you are older, a Roth still may make sense. Normally with an IRA, at age 70 ½ you are required to withdraw from your IRA through mandatory required distributions. However, with a Roth, there is no mandatory withdrawal rule allowing you more time to accumulate tax-free. Also, under the present tax laws, converting a traditional IRA to a Roth can lower the size of your taxable estate. This type of prudent estate planning could allow for decades of tax-free growth for those converted assets.
A few additional estate planning points: If you name your spouse as the beneficiary of your Roth IRA, your spouse can treat the inherited IRA as his or her own after you die and forego withdrawals. This allows those Roth IRA assets to keep compounding untaxed across the rest of your spouse’s lifetime.
Your spouse could then name a son or daughter as a beneficiary. This would allow your children the choice to make minimum withdrawals according to his or her life expectancy. All the while these assets continue growing completely tax-free.
Here’s why you may want to think twice about converting to a Roth
For starters, you will pay taxes now! The IRS treats a conversion from a traditional IRA to a Roth IRA as a taxable event. You will have to pay taxes on the amount you convert. Do you have enough in savings to cover these taxes? If not, you do not, I repeat do not want to pay for the taxes out of your current IRA.
You may be tempted to use your current IRA assets to pay for the tax on the conversion. Here’s why that is not a good choice. First off, if you’re under 59½, you’re facing a 10% penalty on the amount you withdraw, and secondly they amount you take out to cover the taxes will lose the chance for tax-free compounding going forward.
Why wait until 2010?
For some who are under the $100,000 adjusted gross income level, you may consider converting in 2009. Here are a few reasons this may make some sense:
- In 2009, any withdrawals from a traditional IRA can be used to fund a Roth IRA. In years past, mandatory withdrawals from a traditional IRA typically couldn’t be deposited into a Roth IRA. But the federal government has suspended mandatory IRA withdrawals for 2009. Any IRA withdrawals made in 2009 are thereby elective withdrawals. So, if your adjusted gross income (AGI) is $100,000 or less, you have an option to fund a Roth IRA with a withdrawal from a traditional IRA – at least through the end of 2009.
- In 2009, you can fund a Roth IRA with after-tax contributions to a 401(k), 403(b) or 457 retirement savings plan. This year, you can take those contributions and convert them to a Roth IRA tax-free, provided your AGI is $100,000 or less. More good news: there is no limit to the conversion amount.
But don’t ignore the potential tax break for those who convert in 2010
If you do a Roth conversion during 2010, you can choose to divide the taxes on the conversion between your 2011 and 2012 federal returns. This does not apply if you convert in 2009.
Before converting from a traditional IRA to a Roth, be sure to consult your tax advisor. This is a very good idea before you arrange any rollover, trustee-to-trustee transfer, or same-trustee transfer of your IRA assets. In any year, you should fully understand the potential tax impact of a Roth conversion on your finances and your estate. Also, remember that while the income limit on Roth IRA conversions will go away in 2010, the income limits on Roth IRA contributions still apply next year and for the foreseeable future.
This article was written by Jay Peroni.
Where to go to Convert your IRA to a Roth
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Below is another article Written by Jason Topp on the subject…
To Roth or Not To Roth – That is the Question
So 2010 is upon us and there is a lot of controversy regarding whether folks should convert their Traditional IRAs to a Roth IRA. Some of you might be wondering what exactly is a Roth IRA, well, here’s the basics:
A Roth is funded with after-tax contributions; the money grows tax-deferred; and withdrawals are TAX FREE!
In other words, you use money you’ve already paid taxes on to fund the Roth, and provided you meet certain qualifications you never have to pay taxes on that money again!
What is a Roth IRA Conversion?
A Roth IRA conversion then is taking money from a Traditional IRA, pulling it out and putting it into a Roth IRA where it will grow tax free.
Sounds good right?
Well, the problem is that whenever you do this you have to pay taxes on the amount you withdraw from your Traditional IRA.
So, let’s say you are converting $5,000 from your Traditional IRA — you would have to tack on 5G’s to your income for the year and pay tax at whatever rate you are at. It’s as if you earned an additional $5,000 of income for the year.
As many of you already know, one big change for 2010 is that anyone can convert to a Roth regardless of income level. Previously, if you made over $100,000 you could not convert to a Roth.
If you convert your IRA to a Roth in 2010, you now have a choice to pay all of your taxes in 2010 or average the taxes owed on the conversion over two years (i.e. pay in 2011 and 2012). Uncle Sam is giving you a choice on when you pay your taxes.
Don’t forget though that 2010 is the last year for the current low income tax rates. The current law plans for higher tax rates in 2011 — so, if you chose to average your tax payments over the two year period in 2011 and 2012, you might get hit with higher tax rates. That Uncle Sam – he’s always got an angle doesn’t he?
Should You Roth It?
Back to the question at hand. Should you convert to a Roth IRA or not?
Usually the answer to such questions is “it depends”. This might be a great year to convert your money to a Roth and potentially pay lower taxes than you would normally if you are in a lower bracket due to retirement or a layoff and you’ve got some cash on hand to cover your taxes!
This is important because if you are under 59 1/2 and use your IRA to pay the taxes on the conversion you’ll get whacked with a 10% penatly on top of the taxes!
Also, although the markets have rebounded significantly, account balances are still off their 2007 highs. If you convert when accounts are lower, it will result in less overall tax paid plust all the earnings and growth will be tax free!
Factors to Consider
- Do you have money to cover your tax liability? Having cash on hand to cover your taxes will help soften the blow.
- Will the money you convert push you into a higher tax bracket? If so, you probably don’t want to do it.
- Do you have non-deductible contributions in your IRA? No taxes are due on the non-deductible portion. *There are some additional factors to consider here that go beyond the scope of this post.
- Are you planning on applying for financial aid for yourself, your spouse or your child? Better think twice about the conversion – conversion income counts on your application.
Ultimately, whether you convert your Traditional IRA to a Roth will not determine your retirement success, there certainly are other factors to consider to help you make a great run at retirement.
Consider these factors and your overall situation to determine whether the Roth IRA conversion makes sense for you in 2010.
{ 19 comments… read them below or add one }
What about Rollover IRAs? I know they’re technically different than the Traditional IRA but do the same rules mentioned in your post apply to the Rollover IRAs?
Very timely post. Hubby and I are considering coverting our traditional IRAs next year. I will probably run our taxes both ways to determine what the additional tax burden would be and go from there.
@ Darrin
Rollover IRA’s would qualify, too. Any type of old retirement plans will qualify as well.
Keep in mind that taxes only have to be paid on deductible contributions as well as investment earnings, so the entire amount of your conversion is not always taxable.
As a result, in 2010, you can fully fund a Traditional IRA with non-deductible contributions, and immediately convert to a Roth IRA without tax consequence.
Because of this “loophole,” the Roth IRA income limits effectively disappear as well.
If I transferred a Roth IRA from one brokerage firm to a different brokerage firm, then does the “have held your Roth account for 5 years or longer” rule apply to the total combined time with both brokerage firms? Or, does the 5 years have to be with the same firm?
@Britt
That is only true if all you have are non-deductable IRAs. If any of your IRAs (if you have multiple) have deductable money(i.e. a rollover IRA) all of your IRAs are treated as such.
Here’s my take (a comment I left elsewhere on this exact issue):
If one retired today, no pension, no other income, it would take over $2M to fill the 15% bracket. As inflation impacts the tax brackets themselves, along with the standard deduction and exemption amounts, it’s not fair to say that since one sees $3M in their account in 30 years that puts them in a higher bracket. Looking forward you’d have to adjust for inflation. If people who are now in the 15% bracket wish to save in a Roth or convert to ‘top off’ that 15% bracket, I have little objection, but those the ‘10 law applies to (earning $100K) are the very people who shouldn’t be using Roth in the first place.
I see a lot of talk about ‘rates going up’ but very little discussion on just what it takes to reproduce the kind of income it would take to simply be at the same level. I suspect few will manage to be in the same bracket at retirement, let alone exceed it regardless of general increases in the tax structure.
There are three main types of IRAs: Traditional IRA:
The contributions you make may be tax deductible. So instead of paying taxes now, you’ll pay taxes on the money your IRA earns when you withdraw it. If you’re in a lower tax bracket at that point, you’ll pay taxes at a lower marginal income tax rate.
Roth IRA: You pay taxes now so that you don’t have to pay tax on any of the profits earned between now and when you start withdrawing the money.
Rollover IRA: This type of IRA is a simple solution if you’ve got a 401(k) or other retirement plan from a past job, and you want to move the money without paying penalties. This is especially helpful if you have several 401(k)s. It gives you more options for how to invest your money, and helps keep things simple by consolidating them into one account.
Hope this helps
Kevin
Kevin – As I understand it, there is no longer a requirement for a special designated Rollover IRA. Money from a 401(k) can be transferred to either a Roth or traditional IRA, and you can transfer the money from those accounts to the next employer’s IRA so long as it goes to a like account.
I am 70 1/2 (in 2010).
I will pay no taxes so far for 2009 due to losses.
Can I convert any Traditional IRA funds to Roth?
Can I convert less than the entire amount of my traditional IRA?
If so can I do it now (after the end of 2009) for the year 2009?
How much must I with-draw from the Traditional IRA this year?
Thanks.
John,
You can convert to a Traditional IRA to a ROTH IRA. You can convert part of your TIRA to a ROTH IRA. Conversions must be completed by the end of the calendar year.
Converting from a TIRA to a ROTH when you have after tax money in your TIRA changes things abit. The IRS looks at all of your TIRAs aa one TIRA.
Doing a conversion when you have the after tax money in your TIRA, the taxable amount of a ROTH Conversion is the ratio of the after tax money to tax deferred money. EXAMPLE: Your tax deferred account(s) have a value of $140,000. You also have made after tax contributions to a TIRA of $30,000.
The after tax TIRA has gains of $10,000. The ratio of your after tax money vs your tax deferred money is $30,000/$150,000. !/5 (20%) of your ROTH Conversion would be taxable regarless of which account you took your Conversion money from.
You must take a Required Minimum Distributon from your Traditional IRA for the year in which you turn 70.5 years. For you that is 2010. Your first RMD must be taken by April 1 of 2011. After that first RMD subsequent RMDs must be taken by December 31. Waiting until 2011 to take the first RMD means you must also take your 2011 RMD by December 31, 2011, and have the appropriate taxes on 2 RMDs for 2011.
How much is your RMD? This depends on a number of things. First you use your TIRA balance as of December 31, 2009. Then depending on your marital status, and the age of your spouse, you select a factor from the appropriate table in appendix C in IRS Pub 590, Individual Retirement Arrangements: http://www.irs.gov/pub/irs-pdf/p590.pdf
I’m sorry, I processed an interupt, and did not finish the previous post.
From the appropriate table in PUB 590′s Appendix C, you find your factor to divide into the previous year end balance. This will give you your RMD.
Example: Your TIRA balance at the end of 2009 is $100,000. You will be 70.5 years old sometime in 2010. Your spouse is the primary beneficiary of your IRA, and your spouse is not more than 10 years younger than you are. Using Table III in the appendix, for Age 70 (birthday is before July 3) we find the factor 27.4. We divide 100,000 by 27.4 and find our RMD amount is $3,649.64.
I am completely boggled by everything that has to do w/IRAs and I cannot find the info I’m looking for anywhere. I opened a $2000 Traditional IRA Savings in 2008 for 2007 tax year ( opened it before April 15th). Then in June of 2009 I converted the Traditional IRA with a balance of $2022.93 to a ROTH IRA. A few months later I needed money to pay medical bills so I took a $1000 distribution from my ROTH. So this year for taxes I got (2) 1099-Rs… one for $2022.93 and one for $1000.00. This is where I get totally confused. Do I pay tax AND a penalty on the conversion or just tax ? And do I just pay a penalty on the $1000 distribution that was taken out of the $2022.93 ??
I don’t understand how much money I’m going to be losing. I haven’t made any more contributions to the ROTH since I did the conversion. So I’m assuming I’m either going to lose $300 or lose $400. I don’t understand how it works on my taxes. I’m trying to do my taxes w/Turbo Tax and it shows my total distributions as $3023. Is this taxed/penalized as a lump sum or individually ?
The FASFA deadline is tomorrow and my daughter will lose her financial aid if I can’t get this figured out ASAP. because I can’t fill out the forms w/o the info. I had no clue it was going to be this complicated. I wish I’d just put the money under my mattress instead !
Sharon,
Here is some information that may help:
Sharon,
It is good that you are making contributions to an IRA! Keep doing this every year you have eaned income.
>>> I have answered your questions below, see the lines that start with >>>
I am completely boggled by everything that has to do w/IRAs and I cannot find the info I’m looking for anywhere. I opened a $2000 Traditional IRA Savings in 2008 for 2007 tax year ( opened it before April 15th). Then in June of 2009 I converted the Traditional IRA with a balance of $2022.93 to a ROTH IRA.
>>> You should have completed form 8606 Part II with your 2009 form
>>> 1040, and paid income tax on the amount you Converted to your ROTH
>>> IRA.
A few months later I needed money to pay medical bills so I took a $1000 distribution from my ROTH.
>>> Not the best idea, but this $1,000 distribution is now tax free. You will need to complete form 8606 Part III and pay the 10% penalty if you are younger than 59.5
So this year for taxes I got (2) 1099-Rs… one for $2022.93 and one for $1000.00. This is where I get totally confused. Do I pay tax AND a penalty on the conversion or just tax ?
>>> You pay just the tax on the amount you converted to your ROTH IRA.
And do I just pay a penalty on the $1000 distribution that was taken out of the $2022.93 ??
>>> If you are age 59.5 or older this is penalty free.
It may be penalty free IF; this is used to pay your medical expenses that exceed 7.5% of your Adjusted Gross Income (1040 line 38).
I don’t understand how much money I’m going to be losing. I haven’t made any more contributions to the ROTH since I did the conversion. So I’m assuming I’m either going to lose $300 or lose $400. I don’t understand how it works on my taxes. I’m trying to do my taxes w/Turbo Tax and it shows my total distributions as $3023. Is this taxed/penalized as a lump sum or individually ?
>>> The tax should only be charged to the conversion amount. Once the
>>> money is in th ROTH IRA, the income tax has been paid. The 10%
>>> penalty is charged to the ROTH Distribution because the Conversion
>>> was not aged 5 years, or meets one of the other exemptions for which
>>> you may be qualified.
>>> On 1040 line 15A, this should be blank, no amount goes here On 1040
>>> line 15B, you put the conversion amount.
>>> Look at 1040 line 58. This refers to Form 5329 where the penalty for
>>> the ROTH Distribtuon is calculated. You will put $1,000 on line #1.
0 on line 2.
$1,000 on line 3.
$100 on line 4.
This $100 goes to your 1040 line 58.
>>>> SUMMARIZING: Complete Form 8606 Part II for your conversion.
………………………………..Complete Form 8606 Part III for your ROTH Distribution.
………………………………..Complete Form 5329 Part I to calculate your penalty.
………………………………..1040 line 15b should only show your Conversion amount.
The FASFA deadline is tomorrow and my daughter will lose her financial aid if I can’t get this figured out ASAP. because I can’t fill out the forms w/o the info. I had no clue it was going to be this complicated. I wish I’d just put the money under my mattress instead !
>>> Yes, FAFSA is not easy.
>>> I hope this helps you with your tax return and then FAFSA.
>>> Clydewolf
Hi,
What is the deadline to make a Traditional IRA to Rtoh conversion? If I decide to make a conversion Feb. 1, 2010 based on my 2009 tax returns figures, can I still report it on 2009 returns? Is there an April 15, 2010 deadline on this conversion?
Your February 1, 2010 Conversion will be reported on your 2010 tax return.
Roth IRA Conversions must have the funds removed from the TIRA no later than December 31 of the tax year.
If you are doing this at your IRA custodian, the Conversion would be completed within a day or 2.
If you are changing custodians as you do the Conversion, it may take a few more days.
If you take the cash from your TIRA, you have 60 days complete your ROTH IRA Conversion. Or you have the same 60 days to get that cash back to some type of IRA.
question? I have a previous 401k that is now a rollover ira….since my contributions where pretax when I was employed at that company, do I have to keep a record of all post tax dollars that I contribute to that rollover ira acct……otherwise at time of withdrawal I would be double taxed on that contribution…I do recceive a form 4598 annually showing me the contributions I made for that year…P.S. are they tax decuctible ??
david – post tax IRA deposits are tracked via Form 8606 along with your tax return.
David,
Your after tax contributions to your IRA are not tax deductable.
However you may qualify for the Saver’s Tax Credit (probably not though)
1040 line 50 (2009).
And as Joe Taxpayer says, file that 8606 each year you make an after tax contribution. If you missed doing so in the past, it would be wise to do those missed year 8606′s now. Form 8606 is a stand alone form.
Form 8606 – http://www.irs.gov/pub/irs-pdf/f8606.pdf
Form 8606 Instructions – http://www.irs.gov/pub/irs-pdf/i8606.pdf
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