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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.

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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 .
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Alicia Waltenberger is an estate and tax planning attorney and wealth planning specialist at TIAA-CREF. awaltenberger@tiaa-cref.org.
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Douglas Rothermich is an estate and tax planning attorney and vice president, wealth planning strategies, at TIAA-CREF. drothermich@tiaa-cref.org.
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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.

In short, tax-deferred IRA accounts generally contain pretax dollars, while Roth IRA accounts contain aftertax funds. In a Roth conversion, taxpayers convert the pretax balances in tax-deferred accounts to aftertax dollars in a Roth IRA.

What Is New in 2010?

The IRS previously allowed singles and married couples filing jointly with modified adjusted gross incomes less than $100,000 the option to convert funds in tax-deferred accounts to Roth IRAs. (Married couples filing separately could not convert funds to a Roth IRA.) These limitations prevented many taxpayers from converting funds to a Roth IRA.

As of January 1, 2010, these limitations have been removed. So, anyone, including married couples filing separately, can make a Roth IRA conversion. Furthermore, in 2010—and only this year—individuals who convert funds to a Roth IRA can, if they choose, spread the income evenly between 2011 and 2012 for tax purposes. In 2011 and beyond, they may still convert funds to a Roth IRA but they must report the converted funds as income that year.

There are several factors that could influence your decision to convert funds. But the most important factor is a comparison between the marginal tax rate in the conversion year and the marginal tax rate in the withdrawal year if not converted—where this latter tax rate is usually a tax rate from a retirement year.

Key Marginal Tax Rate Comparison

If a taxpayer converts funds in 2010, he will be able to choose between reporting all converted funds in 2010 or splitting the converted funds into equal parts and reporting each half as taxable income in 2011 and 2012. For simplicity, we will assume the taxpayer chooses to report the income for 2010, which will likely be the preferred option for most individuals.

If the taxpayer opts for this strategy, he will convert funds to a Roth IRA and pay taxes in 2010. Then he will retain the funds in the Roth IRA until withdrawing them at some point in the future.

Alternatively, the taxpayer could keep the funds in a tax-deferred account. Under this scenario, no taxes would be paid until a withdrawal is made at some point in the future.

The key difference between these strategies is whether taxes will be paid at the 2010 marginal tax rate or the marginal tax rate in the year the funds are withdrawn in the future, if the taxpayer does not convert to a Roth IRA.

In comparing the two strategies, let’s assume we are deciding whether to convert $1,000 of pretax funds in a 401(k). We will also assume that taxes are paid with the converted funds. If the funds are converted in 2010, the aftertax value will be $1,000 less the amount paid in taxes. (If the tax rate is 30%, the aftertax balance will be $700.) If the funds are left in the 401(k) instead of being converted, the balance will remain unchanged. At the future date of withdrawal, however, the balance will be reduced by the marginal tax rate the taxpayer qualifies for at that time. In both cases, the funds will be invested in the same asset and will increase at the same rate of return.

If the 2010 marginal tax rate equals the expected marginal tax rate at the time of withdrawal, then the taxpayer should be indifferent between converting or not converting funds to a Roth IRA. If the 2010 marginal tax rate is lower, it makes sense to convert to a Roth IRA. (The post-tax balance will be greater at the time of withdrawal.) If the 2010 marginal tax rate is higher, the funds should not be converted to a Roth IRA. (The post-tax balance will be smaller at the time of withdrawal.) The key factor in the decision to convert funds is the comparison between the two marginal tax rates.

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Table 1 illustrates the importance of factoring in both the current and expected future tax rates. (The calculations assume a withdrawal will be made in the future, after the funds have achieved a pretax return of 100%.)

  Scenario A Scenario B Scenario C
    Not   Not   Not
  Convert Convert Convert Convert Convert Convert
Tax Rate in 2010  30% 30% 20%
Tax Rate in Withdrawal Year 30% 20% 30%
Pretax Balance $1,000 $1,000 $1,000 $1,000 $1,000 $1,000
Tax on 2010 Conversion $300 $0 $300 $0 $200 $0
Balance After Conversion $700 $1,000 $700 $1,000 $800 $1,000
Withdrawal Amount in             
n Years After 100% Return $1,400 $2,000 $1,400 $2,000 $1,600 $2,000
Tax on Withdrawal in n Years $0 $600 $0 $400 $0 $600
Balance  $1,400 $1,400 $1,400 $1,600 $1,600 $1,400

Scenario A indicates that if the federal-plus-state marginal tax rates are 30% both today and in the future, the aftertax balance will ultimately be the same regardless of whether a conversion is made or not.

Scenario B illustrates that the taxpayer with a lower tax rate in retirement should not convert funds to a Roth IRA in 2010. In this example, the 2010 marginal tax rate is 30%, while the tax rate n years hence is 20%. If converted to a Roth IRA, the $1,000 of pretax funds will be worth $700 after taxes in 2010 and $1,400 after taxes n years in the future. If not converted, the $1,000 before taxes will be worth $2,000 before taxes in the future, and $1,600 net of taxes after the withdrawal is made. As the math indicates, there is an advantage to not converting if the tax rate is projected to be lower in the future.

Scenario C illustrates that a taxpayer who expects his tax rate to be higher in the future should convert funds to a Roth IRA. In this example, the 2010 marginal tax rate is 20%, while the expected future tax rate is 30%. If the funds were converted today, the $1,000 of pretax funds will be worth $800 after taxes in 2010 and $1,600 after taxes in the future. If the funds are not converted, the $1,000 balance will grow to $2,000 before taxes, but because of the higher tax rate, the taxpayer will only receive a post-tax withdrawal of $1,400. In other words, there is an advantage to converting now if a higher tax rate is expected in the future.

When possible, taxpayers should pay the taxes on the converted amounts with funds held in a taxable account. To understand why, let’s return to the example in Scenario A except assume there is a separate taxable account containing $300. The taxes on the conversion would be $300. If they are paid out of the Roth IRA, then the Roth IRA balance declines to $700. Alternatively, if funds are used from a separate taxable account, the Roth IRA balance stays at $1,000.

The funds in the Roth IRA will grow on a tax-exempt basis. This means, at the time of withdrawal, the full rate of return (e.g., 5% per year) will be realized. In contrast, taxes will be charged on interest that occurs in the taxable account. As a result, the 5% rate of return is effectively reduced to a 3.5% rate of return. By paying for the conversion with funds from a taxable account, the taxpayer maximizes his realized return.

Recharacterizations

A recharacterization undoes a Roth IRA conversion.

For example, say a taxpayer just converted $25,000 to a Roth IRA in early 2010. An uncooperative market causes the portfolio to fall over the next several months and by September 1, 2010, the balance is just $20,000.

Other Factors Affecting the Conversion Decision

There are other factors that may influence the decision to convert funds to a Roth IRA. These factors may be especially important if the marginal tax rate in the conversion year and expected tax rate in the withdrawal year in retirement are approximately the same.

  • Required minimum distributions. There are no required minimum distributions (RMDs) on a Roth IRA, while there are required minimum distributions from tax-deferred accounts. This factor favors the conversion. (RMDs do exist for a Roth 401(k) and a Roth 403(b), but, at retirement, the funds from these accounts can be rolled into a Roth IRA. Doing so effectively avoids the minimum distribution requirement.)
  • Size of Medicare Part B premium and taxation of Social Security benefits. Funds converted to a Roth IRA are counted as taxable income in the conversion year. Thus, Roth conversions will increase that year’s taxable income and, consequently, may increase both the Medicare Part B premium and the taxable amount of Social Security benefits for the same year. In contrast, withdrawals from a Roth IRA are tax free if the account has been in existence for at least five years and the individual is at least 59½ years old. This factor usually favors converting funds, especially if the conversion occurs before age 65 or before Social Security benefits begin.
  • Tax diversification. Taxpayers who have substantial funds in tax-deferred accounts can reduce the risk of higher tax rates in the future by converting some of the money into a Roth IRA this year. The converted funds will be taxed at this year’s tax rates, while the funds left in the tax-deferred accounts will be taxed at future tax rates. By converting some funds to a Roth IRA this year, the risk of potentially higher tax rates in the future is reduced. On a related theme, high-net-worth taxpayers who anticipate Congress will increase their maximum tax rate should find it attractive to convert at today’s relatively low tax rate.
  • Beneficiary considerations. Pretax funds in tax-deferred accounts will eventually be subject to taxes. Consider a retired widow who is considering a Roth conversion and has a son as her beneficiary. The pretax funds will be taxed: 1) at her tax rate in the conversion year, 2) at her tax rate when the funds are withdrawn later in retirement, or 3) if she dies before withdrawing the funds, at her beneficiary son’s tax rate. If she is facing a potentially terminal illness, her tax bracket and her son’s tax bracket will need to be considered before a decision on whether to convert the funds can be made. If she has a higher tax bracket than her son, then she should not make a conversion. On the other hand, if her son has the higher tax rate, everything else the same, she should convert the funds to a Roth IRA. A third scenario would be if she plans to leave funds to a qualified charity. In this case, the charity would receive the greatest benefit if the funds were not converted.
  • Itemized deductions. Taxpayers can deduct certain expenses to the degree they exceed a percentage of adjusted gross income (AGI). For example, medical expenses are deductible to the degree they exceed 7.5% of adjusted gross income. In the year of conversion, the extra taxable income inflates adjusted gross income. As a result, it may be more beneficial to refrain from converting funds to a Roth IRA. Similarly, it may beneficial to convert funds in a given year when those itemized deductions cannot be taken. This factor could either encourage or discourage conversion in a particular year.

Since the taxpayer converted $25,000 worth of funds, he is liable for taxes on $25,000 worth of income—even though the current account balance is just $20,000. This liability can be avoided if the taxpayer elects to recharacterize the Roth IRA, which effectively undoes the Roth conversion and changes the funds back into a tax-deferred account.

The taxpayer could reconvert these funds back into a Roth IRA on the later of January 1, 2011 (i.e., the first day of the next tax year) or October 1, 2010 (i.e., 30 days later).

In practice, the limitation on when funds can be converted back into a Roth IRA should seldom be a problem. The restriction only affects the $20,000 of assets that were recharacterized on September 1, 2010. Any other tax-deferred funds can be converted at any time. So, on September 1, the taxpayer could: 1) recharacterize the original $25,000 conversion from assets that are now worth $20,000, and 2) convert another $25,000 of his tax-deferred accounts to a Roth IRA to attain the desired 2010 conversion.

Whenever funds are converted, they should be placed in a “new” Roth IRA account (as opposed to an existing Roth IRA account). The advantage of having a “new” Roth IRA account is that it is easy to identify the funds to be recharacterized. When the funds are comingled, it is hard to associate “net income” (or “net loss”) with the exact converted funds. To make things easier, converted funds should be held in “new” Roth IRA accounts until the end of the recharacterization period. After the recharacterization period ends, funds in the “new” accounts can be moved to the “old” Roth IRA account.

To take this strategy one step further, suppose the taxpayer converts $25,000 and wants to invest it in five separate mutual funds worth $5,000 each. Five “new” Roth IRA accounts could be formed, one for each mutual fund. Doing so would allow the taxpayer to directly identify which accounts have lost money, simplifying the recharacterization process.

In summary, the option to recharacterize is a valuable option. By converting funds early in 2010, the taxpayer has the option to recharacterize the converted funds if the market value falls. If the market value rises, in early 2011 the taxpayer may want to recharacterize any amounts that would cause his 2010 taxable income to be taxable at a “high” tax rate. This strategy allows the taxpayer to convert precisely the amount of funds needed to take taxable income to the top of a “low” tax bracket.

Recharacterizations must be made on a “trustee-to-trustee” basis. Contact your Roth IRA administrator before making a recharacterization.

Non-Deductible IRAs

Income limits prevent many people from making tax-deductible contributions to a traditional IRA. However, higher-income taxpayers may still be able to convert funds to a Roth IRA.

Consider a single taxpayer, age 60, whose 2009 income prevents her from contributing to a Roth IRA or deducting IRA contributions to a traditional IRA. On December 31, 2009, she makes a $6,000 non-deductible contribution to a traditional IRA. She establishes the traditional IRA at a brokerage firm and invests the funds in a money market fund. On January 2, 2010, she converts the $6,000 to a Roth IRA.

She would owe taxes on the deferred returns, but in this example there would be no deferred returns since the $6,000 is already aftertax funds. This strategy allows her to indirectly, but legally, contribute to a Roth IRA in 2009 even though her income level prevented her from directly contributing to a Roth IRA. Furthermore, she could repeat this strategy in 2010 and in future years.

Complications may prevent her from using this strategy. Suppose at the end of 2009 she had $30,000 in traditional IRAs, including the $6,000 non-deductible contribution for 2009. Unfortunately, the IRS will not allow her to withdraw the non-taxable portion first. Instead, the IRS requires that all withdrawals and conversions be taken on a pro-rata basis from taxable and tax-free funds in all her non-Roth IRAs as of the end of the prior year. So, the $6,000 withdrawal in early 2010 would be considered $1,200 or 20% tax-free return of principal and $4,800 taxable. Therefore, this strategy may be most attractive to taxpayers who do not already have funds in a traditional IRA.

Conclusion

The income restriction for converting pretax IRA funds to a Roth IRA has been removed. Before taking advantage of this change, investors need to compare the marginal tax rate in the conversion year with the marginal tax rate in the withdrawal year. The difference between the two rates will help determine whether converting makes sense for your particular financial situation.

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 AL 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 NY 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 TX 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 OH 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 IN posted over 3 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 OH 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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