Roth Conversions

In the next few weeks Americans will be inundated with a media onslaught recommending that they convert, convert, and convert to Roth IRAs immediately because of the special rules for 2010. In 2010 the normal $100,000 gross income limit applied in earlier years is removed, and the taxpayer has the option of deferring the taxable income to the years 2011 and 2012. 

Characteristics of the Roth IRA

The Roth IRA is a non-deductible savings account, whose earnings and withdrawals are non-taxable after two basic rules (with exceptions) are met; attainment of age 59 and ½, and holding the money in the account for five years. For 2010 the deposit may be made at any time from January 1, 2010 through April 5, 2011. The maximum 2010 deposit is $5,000 per taxpayer, with an additional $1,000 allowed if the taxpayer is over age 49 on December 31, 2010.  

Because Roth contributions are not deductible, they are not reported on the tax return, but the account must be separately established and maintained as a Roth IRA. The 2008 Military Tax Relief Act permits contributions of military death benefits and military insurance proceeds to Roth IRAs and Coverdell ESAs without regard to dollar limits. Non-working spouses may make Roth contributions following the same rules as used for traditional IRAs. Finally, contributions to traditional IRAs reduce allowable Roth IRA contributions for the same tax year and vice-versa. However, contributions to other pension plans and SEPs or SIMPLEs do not reduce the allowable Roth IRA contribution amount. 

In order to deposit money into the account the taxpayer must have earned income that falls under the IRS imposed limits. For 2010 the limits are: 

In contrast to the traditional IRA, the Roth account holder has no requirement to take money out at age 59 and ½. Additionally, the taxpayer may continue to make Roth deposits in years after reaching 70 and ½ as long as the taxpayer has earned income.  

Parents may pass their Roth IRA to their heirs, and the heirs do not pay tax on any distributions from the Roth IRA, as long as the parents have reached the 5 year test. Older parents who no longer qualify for IRA contributions, but who continue to work may wish to fund Roth IRAs as a tool to pass the assets AND the appreciation to the kids without income tax! 

Conversion Rules: 

1.    Convert any account. 

In 2008 Congress substantially relaxed the rules limiting conversions to Roth IRAs. This IRS table at www.irs.gov/ep provides an excellent summary of rollover rules.

2.    Convert Any Amount 

The taxpayer has total flexibility on the amount to be converted. Partial, complete or no conversions of individual accounts, some accounts, all accounts, different types of accounts and different amounts are allowed, based solely on the taxpayer’s individual decisions. 
 

3.    The fair market value is taxable on the date converted 

The conversion itself creates taxable income at the value of the account on the date converted. The value of common stock, bonds or mutual funds will be included in income and reported to the taxpayer on Form 1099-R. The 1099-R should reflect Code 2 if the taxpayer is under age 59 and ½ on the date of conversion, or Code 7 of the taxpayer is 59 and ½ or over on the date of conversion. 
 
 
 

4. There is no automatic tax due on the conversion 

Although the conversion creates taxable income, it does not necessarily create tax due. If the taxpayer has low income, losses from other activities, large itemized deductions, personal exemptions or other items, these losses and deductions may be used to reduce any potential tax burden from including the converted amounts in income in 2010. 
 

5. There is no penalty on conversion 

The actual conversion and inclusion in income of the converted amount does not cause penalty, because conversions are specifically excluded from any early withdrawal penalty. 
 

6. Where will the money come from to pay the tax? 

Here is an interesting question that is ignored by the conversion sales people. If the taxpayer takes money out of their IRA to pay the tax, then it is treated just like any other IRA withdrawal, meaning if the converting taxpayer is under age 59 and ½ a 10% penalty will apply on any conversion money used to pay tax rather than converted to the Roth!. Similarly if money is withdrawn from the Roth to pay the tax, that money has not been in the account for 5 years and will also be subject to a 10% early withdrawal penalty unless the taxpayer is over age 59 and ½! Meaning that the taxpayer had better have some separate cash available outside of retirement accounts to pay any tax arising from the conversion. Don’t forget if the taxpayer is receiving Social Security during the conversion year, the income exclusion could also make more of the Social Security taxable. 
 

7. Will tax rates rise in 2011 and 2012? 

For taxpayers who choose to defer converted income in 2010 (only) to future years, the conversion will be included ½ in 2011 and ½ in 2012. With the distinct possibility that the future rates will be substantially higher than 2010 rates, the taxpayer may wish to pay ALL of the tax in 2010. The nice thing is the decision will not have to be made until April 15, 2011. 
 

8. Do not co-mingle the conversion money into an existing Roth! 

Possibly the most overlooked conversion issue is the co-mingling issue. When a taxpayer mingles conversion money into a traditional contributory Roth IRA two bad things can happen. First, if the converted assets decline in value the taxpayer may wish to re-characterize back to the traditional IRA, and this may be impossible once the funds are co-mingled.  

More importantly, converted money uses its own 5-year holding period. This means that co-mingled contributory/converted Roth IRAs will use the new conversion date to calculate the beginning of the 5 year holding period, rather than the old contributory date. This could be disastrous for an individual planning on utilizing the old contributory Roth accounts in the near future! 

*this article was written by Bob Jennings and I thought it was full of good information