Roth Conversion - What You Need to Know

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In 2010 the 0,000 income threshold for Roth conversions goes bye bye, and the rules surrounding Roth Iras are complicated, with serious tax and income implications for the unprepared.

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How is Roth Conversion - What You Need to Know

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First, have you ever wondered why Congress created this random rule allowing high-income habitancy to convert to a Roth starting in 2010? Turns out it was a bit of budget sleight of hand. Congress wanted to keep the cost of the Tax growth prevention and Reconciliation Act of 2005 (Tipra) under billion while the 10-year budget window in order to prevent a point of order or filibuster that would have required 60 votes to override. So, as a income offset, Congress inserted the provision allowing high-income taxpayers to convert to a Roth starting in 2010. Foreseen, tax revenues: .4 billion.

In the long run, this .4 billion windfall will cost the government billion in time to come tax revenues in present-value terms, according to an analysis by the Tax course Center. So there you have it: your general justification for doing Roth conversions. In the aggregate, Americans will spend .4 billion to save billion. Fine by me: The government's loss is my clients gain.

One of the most under appreciated benefits of Roth Iras is that there are no minimum distribution requirements while the Roth holder's lifetime. habitancy who have not yet reached age 70½ may not fully understand the power of this benefit. But when they start having to pay taxes on income they don't need, they may wish they had converted to a Roth earlier, when the account was smaller and the taxes were lower.

People are living longer today. Seventy is the new 50. Baby boomers who plan to work past age 70 not only won't want to take Rmds, they may want to keep contributing to an Ira so that when they finally do retire, they'll be set for life. Converting to a Roth Ira eliminates the need to take unwanted assessable distributions and allows the account to grow tax free well into your 70s, 80s, or 90s.

When you factor in the assorted stealth taxes and means testing that high-income retirees are branch to, the value of tax-free income is even greater than a straight tax-bracket comparison would indicate.

The special rules for 2010

As I noted earlier, anyone may convert a customary Ira to a Roth starting in 2010. The 0,000 income limitation does not apply. As an further enticement, the income is reported over two years, starting with the 2011 tax year. So a conversion in 2010 would be required to only description half the income on his 2011 return (paying the taxes by April 15, 2012) and the second half on his 2012 return (paying the taxes by April 15, 2013). The conversion itself would be reported in 2010 using Form 8606, but none of the income is reported for that year unless the client opts out of this special rule.

Timing the conversion

The best time to convert to a Roth is when the account is down in value. That's because taxes are based on the value of the account at the time of conversion. I suggest converting early in the year, for two reasons. First, the taxes aren't due for a full 15 months after the conversion-or in the case of the special rule for 2010, 27 months. And second, converting early in the year offers a longer occasion to undo it if investments perform poorly afterward. The deadline for re-characterizing a Roth conversion is Oct. 15 of the year after the conversion. For example, a conversion done in January 2010 offers 21 months of hindsight-until Oct. 15, 2011. If the account dips in value, you may want to take advantage of the Roth "oops" rule and "Un-do" the conversion.

Partial conversions

It is perfectly approved to convert part of the account. Clients who want to hedge their tax bets in retirement may prefer to hold assets in both customary and Roth Iras. A partial conversion reduces the tax hit now and hedges against the possibility that the conversion was a mistake that won't be recognized until it's too late to re-characterize (for example, if you end up being in a much lower tax bracket in retirement). A partial conversion also leaves the door open to converting the remaining number should the account fall in value or should other circumstances change.

The foremost thing to know about partial conversions is that if any part of the account is made up of nondeductible contributions, you can't cherry-pick the nontaxable part. Rather, the converted number must enunciate the same ratio of assessable and nontaxable contributions as found in all the client's Iras in the aggregate, including traditional, Sep, and uncomplicated Iras. For example, if all Iras are worth 0,000, and ,000 is made up of after-tax contributions, 25% of any number converted-regardless of which account it is taken from-will be considered nontaxable.

Converting a 401(k) or 403(b) to a Roth Ira

Assets in 401(k) and 403(b) plans may now be converted directly to a Roth without stopping for a customary Ira rollover first. The assets must be available for distribution, which means old 401(k)s from previous jobs are the most likely pool of assets to tap. You can arrange an in-service non-hardship retirement may be able to convert 401(k) assets from their gift job. The rules for converting 401(k) and 403(b) assets are dissimilar than for Iras. Each account stands on its own for the purpose of determining the nontaxable portion. So if you have complicated 401(k) accounts with several previous employers and want to convert just one account, the proportion of assessable to nontaxable money will be anyone it is for that account without regard for the others.

The rule against cherry-picking still applies to that one account, however. So if a client has 0,000 in a 401(k), and ,000 of it is after-tax money, he can't direct only the ,000 to a Roth for a nontaxable conversion. If you convert any part of the account, 80% will be assessable and 20% will be nontaxable. However, there is a way to get around this rule. If you want to convert only the nontaxable part of a 401(k) in order not to pay taxes on the conversion, here is what you have to do:

1. Request a retirement of the entire balance (important).
2. Within 60 days, put an number equal to the pretax dollars (,000 in the example above) into a customary Ira.
3. Then put an number equal to the after-tax dollars (,000 in the example) into a Roth Ira. Make sure all is done within 60 days.

I hope this helps you understand the nuances of Roth conversions. As retirement planning specialists, we are dedicated to staying on top of the confusing and ever-changing rues for our clients.

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