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New Rules for Converting to a Roth IRA

by William Reichenstein , Alicia Waltenberger and Douglas Rothermich

New Rules For Converting To A Roth IRA Splash image

The New Year removes a key restriction for many individuals—the ability to convert pretax funds to a Roth IRA. Prior to January 1, 2010, only taxpayers who met certain income requirements were allowed to convert funds in a tax-deferred account (e.g., traditional IRA, 401(k), 403(b), 457, SEP-IRA) into a Roth IRA. Now this restriction has been removed. Since you will still have to report the converted funds as income and pay the associated taxes, you need to consider whether converting funds to a Roth IRA is beneficial for your particular financial situation.

Tax-Deferred Accounts Versus
Tax-Exempt Roth Accounts

Tax-deferred accounts such as traditional IRAs and 401(k)s generally contain pretax dollars. Funds in tax-deferred accounts grow tax deferred until distribution. Withdrawals are taxed as ordinary income. Withdrawals (but not conversions) made before age 59½ are generally subject to an additional 10% penalty tax. Relatively few taxpayers have made non-deductible (aftertax) contributions to a traditional IRA or other tax-deferred accounts, in which case they would have a mix of pretax and aftertax funds in these accounts. We discuss these exceptions later. For now, we assume tax-deferred accounts contain only pretax dollars.
In contrast, Roth IRAs, Roth 401(k)s, and Roth 403(b)s contain aftertax dollars. Withdrawals from these tax-exempt accounts are tax free as long as the individual is at least 59½ and the funds have been in the Roth account for at least five years.

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William Reichenstein , CFA, holds the Pat and Thomas R. Powers Chair in Investment Management at Baylor University and is head of research at Social Security Solutions, Inc .
Alicia Waltenberger is an estate and tax planning attorney and wealth planning specialist at TIAA-CREF. awaltenberger@tiaa-cref.org.
Douglas Rothermich is an estate and tax planning attorney and vice president, wealth planning strategies, at TIAA-CREF. drothermich@tiaa-cref.org.


Discussion

John from Alabama posted over 3 years ago:

Is it true that future gains in a Roth are also tax-exempt? If so, why was this not mentioned as a factor to consider in the article? Assuming a 10% annual return and being 20 yrs from retirement, the taxable amount could be over 400% higher if not converted. Wouldn't this then reduce the total tax burden by 75% if converted?
Thanks!


Marie from New York posted over 3 years ago:

Yes, gains are also tax exempt. That's why they say the longer you leave money in a Roth IRA, the more advantageous it is. There is a break-even point, and after that, the advantage grows as the gains grow.


Don from Texas posted over 3 years ago:

If you take the conversion in 2010 and then apply the conversion 50/50 over 2011 and 2012 what paperwork is required by the IRS on your filing on the 2010 returns and likewise on the 2011 and 2012? Diluting the conversion income over 2011 and 2012 should make for a better tax senario shouldn't it (all things remaining equal hopefully...)


Philip from Ohio posted over 3 years ago:

John,

Yes, it's true that the gains in the Roth are exempt. However, in practice that's not really a difference between the Roth and the Traditional IRA. To illustrate, consider the following example (using round numbers for simplicity).

Suppose that someone 10 years from retirement, has $10,000 to invest, their tax rate is 25%, and you're trying to decide between a Roth and a traditional IRA. Also, assume that their tax rate will be 25% when they withdraw the money in 10 years. Now assume that over that 10 year period their IRA investment grows to 3x its original size.

If they invest in a Roth, they will pay $2500 in taxes this year, so they will have $7500 left to invest in the Roth. At the end of 10 years, this will have grown 3x and will be worth $22,500, which they can withdraw tax-free.

If they invest in a traditional IRA, they will pay no taxes this year, so they can invest the whole $10,000. After 10 years it will have grown 3x to $30,000. At withdrawal, they will pay 25% tax, so they will net 75% of $30,000, which is $22,500--same as the Roth.

Net: As the article points out, the critical decision factor is whether the tax rate is higher or lower now vs. at withdrawal. The fact that earnings are tax-free is a wash.


David from Illinois posted over 2 years ago:

The recommendation to keep five funds of $5,000 in separate Roth accounts reminds me of grandma's budget-keeping with envelopes of cash for each of the utility companies. If there are five funds i want to bet on over a period of a potential recharacterization and i leave dividends reinvested in each of the five, the bookkeeping doesn't sound too complex. Is there some other complexity?


Eric from Ohio posted over 2 years ago:

In the example used in the last paragraph preceding the Conclusion, it states that the $6000 would be considered as part of the $30,000 in traditional IRAs (including $6000 non-deductable contribution for 2009). This would result in the following, "So, the $6,000 withdrawal in early 2010 would be considered $1,200 or 20% tax-free return of principal and $4,800 taxable."

Based on the above, are the $24,000 in the traditional IRA (excluding the 2009 $6,000 contribution) composed of contributions only or contributions and returns?

For example, if the $24,000 was represented by a prior period $4,000 deducted contribution, $6,000 nondeducted contribution and $14,000 of gains on the contributed, $10,000, how would the taxed be calculated?

Will taxes be due on $18,000 of the $24,000 or some other amount? If some other amount, how would this amount be calculated?

Thank you in advance,


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