The Pension Protection Act of 2006 (PPA) provided for Rollovers to Roth IRAs beginning January 1, 2008. Making a Good Deal for Retirement Even Better discusses how the AGI income limitation for most individuals will be eliminated in 2010 and how to prepare for any IRA conversions.
It discusses how you can pay the taxes in 2010 or take advantage of a one-time option to spread the converted amount equally over your 2011 and 2012 tax returns:
The law does provide some wiggle room, however: You can report the amount you convert in 2010 on your tax return for that year. Or, you can spread the amount converted equally across your 2011 and 2012 tax returns, paying any resulting tax in those years. For example, if you convert $50,000 next year and choose not to declare the conversion on your 2010 return, you must declare $25,000 on your tax return for 2011 and $25,000 on you return for 2012. The two-year option is a one-time offer for 2010 conversions.
As tempting as the conversion sounds, the article discusses how it makes no sense to convert if you are using the IRA to pay the taxes:
Financial planners uniformly say it makes no sense to convert to a Roth unless you can pay the taxes from a source other than your IRA. If you need to tap your IRA for the tax money, you're defeating, in part, the purpose of the conversion: to maximize the long-term value of the Roth.
You will still be responsible for any Required Minimum Distributions (RMDs), noting that 2009 RMDs were waived by WRERA.
It also discusses the strategy of maxing out your IRA contributions and then converting them to a Roth and the benefits of setting up two sets of accounts for each investment:
John Blanchard, a 41-year-old executive recruiter in Des Moines, Iowa, has "maxed out" IRA contributions for himself and his wife since 2006 in anticipation of the 2010 rule change. He plans to convert about $34,000 in holdings next year. "If they would let me do more, I would do more," he says. "This planning is purely for retirement."
You could continue this strategy each year after that—opening a traditional IRA and converting it to a Roth. In fact, you would have to use this approach if your income exceeds the limits for making Roth contributions.
But how do you do this—over a number of years—without winding up with multiple Roth accounts? Mr. Slott recommends holding two Roths. When you first convert the assets, put them in your "new" Roth. That way, if that holding suffers a loss in the first year, you can recharacterize it as a traditional IRA so you don't have to pay tax on value that no longer exists. (More on that below.) If the account increases in value before that deadline expires, you could then transfer the assets to your "old" Roth—after the time to recharacterize expires. Each year, you could repeat those two steps…
It's also a good idea to put converted holdings in a new account, rather than an existing Roth. Here's why: If the value of your converted assets falls further—after you have paid taxes on their value—you can change your mind, "recharacterize" the account as a traditional IRA, and, in turn, no longer owe the tax. Later on, you could reconvert the assets to a Roth again. (See IRS Publication 590 for the timing details.) This dilutes the tax benefit if you've combined those converted assets with other Roth holdings that have appreciated in value.
In fact, you might consider opening a separate Roth for each type of investment you make with the converted money. That way, you could "cherry-pick the losers," recharacterizing investments that perform poorly, suggests Mr. Slott. Let's say you made two types of investments—one that doubled in value and another that lost everything. If those investments were in the same Roth, the account value would appear unchanged. But if they were in separate accounts, you could recharacterize the one that suffered—and allow the one doing well to continue appreciating in value as a Roth.
The advantages of Roth IRAs include tax-free withdrawals (generally), tax diversification, no Required Minimum Distributions (RMDs) requirements, and your heirs don't owe income taxes on withdrawals (though the Roth assets are included in an estate's value and must be taken over the lifetime of the beneficiary)
You can choose to roll over all, none, or a portion of an IRA balance, how you should try to avoid rolling over qualified plan assets into the IRA prior to conversion, and the complications created by the pro-rata rule:
The trickiest part of paying the tax for a Roth conversion involves the IRS's pro-rata rule. In short, you can't cherry-pick which assets you wish to convert.
Let's say you have a rollover IRA (from an employer's 401(k) plan) with a balance of $200,000, and an IRA with $50,000. The latter contains $40,000 in nondeductible contributions made over a number of years. As much as you might wish, you can't convert the $40,000 alone—tax-free—to a Roth IRA.
Rather, you have to follow the pro-rata rule. The IRS says you must first add the balance in all your IRAs—in this case, $250,000. Then you divide nondeductible contributions by that balance: $40,000 divided by $250,000. This gives you the percentage—16%, in our example—of any conversion that's tax-free. So, let's say you want to convert $30,000 of your two IRAs to a Roth. The amount of the conversion that would be tax-free would be $4,800 ($30,000 x 0.16)….
"If you're thinking about doing a Roth conversion, leave your 401(k) alone" rather than rolling it into an IRA beforehand to keep your share of nondeductible contributions higher in the calculation above, says John Carl, president of the Retirement Learning Center LLC in New York, which works with investment advisers. And if you've already rolled over your 401(k) into a traditional IRA, you may want to roll it back—a move that many employer plans allow, he adds.
To prepare, you should fund an IRA before December 31, organize your paperwork and prepare documentation for any nondeductible IRA contributions, and determine how you are going to pay for the taxes
The article also includes an Interactive graphic and a link to a Roth Calculator. Other online calculators are also available to assist those who would like to use real numbers:
- The Motley Fool – Which will provide more retirement income?
- Roth 401(k) or Traditional 401(k)? – Use this calculator to help determine if a Traditional 401(k) or Roth 401(k) might be best for you.
- Roth IRA Calculator – Use this calculator to compare the Roth IRA to an ordinary taxable investment.
- Roth IRA Conversion – This calculator will show the advantage, if any, of converting your IRA to a Roth.
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