Should You Convert to a Roth IRA? (Part 3)

Should You Convert to a Roth IRA? (Part 3)

I must reiterate that I am not quite sure how long this series will end up being. My intention is to discuss the salient points that you, as an investor, must understand and take into consideration as you decide whether or not converting to a Roth IRA is something that will benefit you and your family. Today, we will begin tackling the tax issues surrounding these conversions.

How Is One Taxed on the Amount Converted?

The answer to this question depends on whether the contributions were made with deductible (pre-tax) or nondeductible (after-tax) funds.

Accounts With Deductible Contributions ONLY

Since the contributions, as well as growth up until the time of the conversion, have never been taxed, the entire converted amount is considered ordinary income in the year of the conversion. There is a special 2010 only exception which I’ll discuss shortly.

By way of an example, say Peter used to work for XYZ Inc. and participated in the company’s 401(k) program by making pre-tax contributions. His 401(k) balance is presently $100,000. Peter is no longer employed at XYZ and now wishes to convert the $100,000 into a Roth IRA in 2010. The entire $100,000 will be added to his income for this year (assuming he’s not using the special exception). However, his taxes will be based on the applicable rate, depending on his taxable income.

It is hugely important that you pay close attention to my choice of words here. As I pointed out in my book, 5 Mistakes Your Financial Advisor Is Making, mistake #1 is still being made by tons of so-called financial advisors/experts: perpetuating the myth that your income always depends on how much money you earn.

Here’s what I mean. Say Peter talks to a savvy strategist from Laser Financial Group, who helps him create legally allowable income offsets to reduce his $100,000 gross conversion income down to $50,000, or completely eliminates any taxable income. Peter would then owe tax on the lower amount ($50,000 or zero), instead of the full $100,000. We continue to help numerous clients to achieve similar results.

Accounts With Nondeductible Contributions ONLY

Such funds will owe tax only on the growth up until the time of conversion. Say Mary contributed $50,000 to a traditional IRA but did not deduct any portion of the contributions for tax purposes. If that IRA now has a balance of $70,000, she will owe tax only on the $20,000 gain. Again, it is important to consider the possibility of reducing or even eliminating those tax consequences.

Accounts With BOTH Deductible and Nondeductible Contributions

The law demands that taxes are paid on a “proportionate share” of the conversion. But what does this mean?

Assume that Katie’s traditional IRA is currently worth $100,000, and $10,000 of her contributions were after-tax. Katie decides to convert $10,000 to a Roth IRA. Only 10 percent (in this case $1,000) of this $10,000 will be tax-free, meaning she will be taxed on 90 percent (or $9,000). By law, 10 percent of the account is tax-free, so 90 percent of the funds released are taxable. If Katie really wants to withdraw all $10,000 tax free, she’ll need to convert the entire $100,000 and pay tax on 90 percent ($90,000). Interesting, isn’t it!

What Is the Special 2010 Exception?

NOTE: This arrangement applies ONLY to conversions completed in 2010. For such conversions, you may decide to either pay ALL of the taxes due in 2010 or split the amount converted – not the taxes due – EQUALLY between 2011 and 2012. These are the only options and they are non-negotiable.

Remember Peter from the earlier example, who wishes to convert $100,000 in 2010? He may recognize the full $100,000 as income in 2010 or include $50,000 as income in 2011 and $50,000 in 2012. However, he cannot do the 50/50 split for 2010 and 2011 – yes, the law is that rigid.

Here is something you must consider as you decide whether to convert your retirement income to a Roth IRA. If you choose to do the 50/50 split in 2011 and 2012, your taxes will be based on your applicable rates in 2011 and 2012, not 2010 rates. As you may already know, the 2001 tax-cuts are due to expire at the end of this year, which means it behooves you to ponder where YOUR future rate is headed, beginning in 2011.

Look for more conversion-related tax information in Part 4 of this series. And if you’ve missed the other segments in this series, read them here:

  Part 1

  Part 2

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Interested in converting your IRA/401(k) with little or possibly no tax consequences, like our clients have done and continue to do? Or do you simply need some advice deciding whether it even makes sense, given your situation, to convert? Please call (301) 949-4449 or visit our website to schedule your free, no-obligation consultation.