Roth IRA Conversions: “What you need to know but may not have known to ask…”

Pre-tax to Roth IRA Conversions

First some basic information…

Who is eligible to convert a pre-tax IRA to a Roth IRA?

Through the end of the 2009 calendar tax year, only individuals whose modified adjusted gross income (MAGI) is $100,000 or less are eligible to convert a pre-tax IRA (or eligible pre-tax distribution from qualified retirement plans, SEPs or SIMPLEs; also see: In-service Withdrawals from Qualified Plans) to a Roth IRA; however… As provided in the Tax Increase Prevention Act 2005 (TIPRA), starting January 1, 2010, the MAGI limit for eligibility no longer applies.

Converting to a Roth IRA

A Roth conversion is essentially a rollover from a pre-tax IRA (or eligible pre-tax distribution from qualified retirement plans, SEPs or SIMPLEs) to a Roth IRA.  The individual taxpayer must report the entire or partial conversion as ordinary income.  The 10% additional penalty tax for distributions prior to attainment of age 59½ does not apply if the conversion is timely executed within 60 days compliant with the applicable rollover rules.

The rules that apply for taxation of distributions from an after-tax IRA also apply to conversions of after-tax IRAs to Roth IRAs.

In 2010 only, the individual taxpayer pays no tax in 2010 on any ordinary income attributable to a Roth conversion distribution.  Any 2010 distribution must be reported as ordinary income as if it was distributed in 2 equal installments in 2011 and 2012However… if the tax payer believes that he/she will be paying tax at a higher rate in 2011 and 2012 than in 2010, the tax payer can elect to pay the entire tax due in 2010.

Roth Recharachterization Rules (Reversing the Conversion)

The Roth recharachterization rules permit the individual taxpayer to transfer converted funds from the Roth IRA back to a pre-tax IRA by the due date of the individual’s tax return (or any extension thereof).  These recharachterized funds must be adjusted for any gains/losses that occur during the intervening time period.

Commentary This article does not formally address the unique technical issues associated with the so-called “Roth Conversion Diversification” schemes that involve the separation of asset classes within multiple IRAs (e.g., bonds in one IRA, aggressive or “alternative” investments in another IRA).  These schemes position the individual taxpayer to convert pre-tax IRAs to Roth IRAs and then perhaps reverse the conversion based on the particular IRA’s gains or losses during the intervening time period.  While these schemes may work, proceed with caution.

Pending Legislation

It has been reported that pending legislation will permit the conversion of non-Roth funds within a qualified retirement plan.  Keep in mind that reported pending legislation does not mean that it will happen.

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Copyright © 2009 Barry R. Milberg   All Rights Reserved

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