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Figuring out how much to convert to a Roth IRA

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Figuring out how much you can afford to convert involves crunching the numbers on the tax cost of a Roth conversion. In general, I am a fan of spreading out tax costs over multiple years. However I do see the mathematical appeal of converting all IRA funds at once in order to take advantage of the tax-free status of Roth IRAs. Here's some tips to aide you in optimizing how much of a traditional IRA to convert to a Roth IRA.

Consider any losses or deductions you will be eligible for in the year of the Roth conversion that could help reduce the tax cost of the conversion.

Consider the cash funds you have to pay the additional tax. If you cannot afford to pay for converting all your traditional IRAs to a Roth, figure out how much you can afford to convert. You can always convert portions of your Roth IRA over multiple years.

Consider the time horizon for your investments. If you are going to need some of your IRA funds in the next five years, keep those in your traditional IRA. Not only does this preserve the tax-deferred status of your IRA, it can help prevent you from incurring a double tax-hit on the Roth conversion.

Special Rule for 2010 Roth Conversions: Spreading out Income over Two Years

When a person converts traditional IRA funds into a Roth IRA, the amount of the Roth conversion is included in income in the year in which the conversion is made.

For the year 2010 only, Roth conversion income is spread over two years, unless the taxpayer elects (chooses) to include all the Roth conversion income on the 2010 tax return. This special rule is worth some discussion. For taxpayers converting to a Roth in 2010, half of the Roth conversion income will be included in the person's 2011 tax return and the remaining half in the person's 2012 tax return.

This rule has the advantage of spreading out the tax impact of a Roth conversion over two years with a one year deferral before payment to the government is due. This could allow a person to save up enough money to fully pay for the Roth conversion. It also allows taxpayers to engage in some sophisticated tax planning to help minimize the impact of a Roth conversion.

This rule has one significant disadvantage. People might see their tax rates increase starting in the year 2011. This scenario envisions that one of the following future events might unfold.

  • If all the tax cuts that Bush signed into law are allowed to expire, then the tax rates that were in effect prior to 2001 will return. This would mean the end of the ten-percent tax bracket. It would also mean that the top tax rates of 33% and 35% will increase to 36% and 39.6%, respectively. Political commentators are unsure if Congress will allow this to happen.
  • President Obama has signaled that it is his wish that the 10% tax rate be continued, but the top tax rates should be increased from 33% and 35% to 36% and 39.6% for taxpayers who earn more $200,000 (or $250,000 for married couples filing jointly).
Thus it is possible that by following the default rule for spreading out Roth conversion income over two years, a taxpayer could unwittingly find herself faced with a higher tax cost of converting to a Roth. Taxpayers earning more than $200,000 per year should be especially wary about the potential for tax rate increases.

Taxpayers can opt-out of the default rule requiring Roth conversion income to be spread out over the years 2011 and 2012. To do so, taxpayers will need to make an election to report all the Roth conversion income in 2010. I urge anyone considering a Roth conversion to run calculations to compare the cost of taking all the Roth conversion income in 2010 versus spreading out that income over 2011 and 2012. On the other hand, if a taxpayer expects to have lower income, significant losses or deductions or credits for 2011 and 2012, it may be cheaper to utilize the default two-year rule.

One Rollover per Year Rule

Under the general rules for all IRAs, a taxpayer is allowed one rollover per year per account. This applies to rollovers from one traditional IRA to another, from one Roth IRA to another, or from a traditional IRA to a Roth IRA. Direct trustee-to-trustee transfers from a qualified retirement plan such as a 401(k) or 403(b) account to an IRA do not count toward the one rollover per year rule. Also, be aware that the rollovers are allowed once per twelve-month period and are counted per IRA account. Any additional rollover after the first rollover is treated as a fully taxable distribution, and an early distribution penalty may apply.

Here's an example of how the IRA rollover rules work from Publication 590:

"You have two traditional IRAs, IRA-1 and IRA-2. You make a tax-free rollover of a distribution from IRA-1 into a new traditional IRA (IRA-3). You cannot, within 1 year of the distribution from IRA-1, make a tax-free rollover of any distribution from either IRA-1 or IRA-3 into another traditional IRA.

However, the rollover from IRA-1 into IRA-3 does not prevent you from making a tax-free rollover from IRA-2 into any other traditional IRA. This is because you have not, within the last year, rolled over, tax-free, any distribution from IRA-2 or made a tax-free rollover into IRA-2."

Reporting the Roth Conversion

Individuals who convert their traditional IRA to a Roth IRA will receive two tax documents and will report the conversion in two places on their tax return.

Taxpayers will receive a Form 1099-R from their financial institution reporting the Roth conversion. It will be coded as a rollover to a Roth IRA. Taxpayers will use the information from From 1099-R to report their Roth conversion income on Form 8606, with the taxable portion of the conversion income reported on their Form 1040. Forms 1099-R are generally send out by the end of January of the following year. Additionally, taxpayers will receive Form 5498 from the financial institution that received the Roth IRA funds. This form reports the value of the funds received and the value of the account at the end of the year. Generally this form is for information purposes only and does not need to go anywhere on a tax return. Form 5468 is generally mailed out by May 31.

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