Roth conversion strategy is a subject that many folks don’t have a firm grasp on, but it can save you a lot of money in the future – so we’re going to spend some time addressing it.
When Roth IRAs were created in 1997, they were an exciting new idea. They provided a way to make after-tax contributions that could, under certain conditions, grow entirely free of federal income taxes.
Prior to that, traditional IRAs worked basically the other way around. You could make deductible contributions, but distributions would be fully taxable. The law also allowed taxpayers to “convert” traditional IRAs to Roth IRAs by paying income taxes on the amount converted in the year of conversion.
Roth IRAs represented a great new opportunity for many people, but there were a couple of legal stipulations that prevented higher income earners from taking advantage of them. First, the annual contributions an individual could make to a Roth IRA were reduced or eliminated if income exceeded certain levels. Second, individuals with incomes of $100,000 or more, whose tax filing status was married filing separately, were prohibited from converting a traditional IRA to a Roth IRA.
But in 2005, Congress passed the Tax Increase Prevention and Reconciliation Act (TIPRA), which repealed the second of those barriers. Starting in 2010, anyone would be allowed to convert a traditional IRA to a Roth IRA, regardless of income level or marital status.
TIPRA did not repeal the first barrier that limited the ability to make annual Roth contributions based on income, but a legal avenue was still opened up by the removal of the second barrier. Since 2010, it has been possible to make contributions to a traditional IRA and then convert all or part of the funds to a Roth. (Note: there is one exception: you generally can’t convert an inherited IRA to Roth. Special rules apply to spouse beneficiaries.)
Many high income earners may still be playing by the old familiar rules simply because they are unaware of the new opportunity. The benefits of a Roth IRA are now accessible through a legal “back door”. There are no limits to the number of Roth conversions you can make.
Under the new TIPRA provisions you can also roll funds over from an employer-based plan, like a 401(k), to a Roth IRA.
Calculating the Conversion Tax
When you convert traditional IRA funds (or SEP IRA funds, or SIMPLE IRA funds) to a Roth IRA, you are liable to pay tax as if you received a distribution, but with one important difference – the 10% early distribution tax doesn’t apply, even if you’re under age 59½. However, the IRS may recapture this penalty tax if you make a non-qualified withdrawal from your Roth IRA within 5 years of your roth conversion.
If you’ve made only nondeductible (after-tax) contributions to your traditional IRA, then only the earnings, and not your own contributions, will be subject to tax at the time you convert the IRA to a Roth. But if you’ve made both deductible and nondeductible IRA contributions to your traditional IRA, and you don’t plan on converting the entire amount, things can get complicated.
That’s because under IRS rules, you can’t just convert the nondeductible contributions to a Roth and avoid paying tax at conversion. Instead, the amount you convert is deemed to consist of a pro rata portion of the taxable and nontaxable dollars in the IRA.
For example, assume that your traditional IRA contains $350,000 of taxable (deductible) contributions, $50,000 of nontaxable (nondeductible) contributions, and $100,000 of taxable earnings. You can’t convert only the $50,000 nondeductible (nontaxable) contributions to a Roth, and have a tax-free conversion. Instead, you’ll need to prorate the taxable and nontaxable portions of the account. So in the example above, 90% ($450,000/$500,000) of each distribution from the IRA (including any conversion) will be taxable, and 10% will be nontaxable.
You can’t escape this result by using separate IRAs. Under IRS rules, you must aggregate all of your traditional IRAs (including SEPs and SIMPLEs) when you calculate the taxable income resulting from a distribution from (or conversion of) any of the IRAs.
Some experts suggest that you can avoid the pro rata rule and make a tax-free conversion if you take a total distribution from all of your traditional IRAs, transfer the taxable dollars to an employer plan like a 401(k) (assuming the plan accepts rollovers), and then roll over (convert) the remaining balance (i.e., the nontaxable dollars) to a Roth IRA. The IRS has not yet officially ruled on this technique, so be sure to get professional advice before considering this.
Is Roth Conversion Right for YOU?
As always, there are a number of factors that go into answering that question. It will depend on your current and projected future income tax rates, the length of time you can leave the funds in the Roth IRA, your state’s tax laws, and how you’ll pay the income taxes due at the time of conversion.
Contact your financial planner to look at your particular situation, and discuss whether a Roth conversion may be of benefit. This is just one of the ideas we can give you advice on to help you preserve more of your savings for retirement.