Thursday, December 10, 2009


For several years now tax professionals, myself included, and personal finance and tax bloggers, again myself included, and financial writers have been talking about 2010 being the year to convert to a ROTH IRA.

Through 2009 taxpayers could not convert traditional IRAs to a ROTH IRA if their modified Adjusted Gross Income was greater than $100,000. And the thresholds for contributing to a ROTH account were even higher.

But, thanks to the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA) beginning in 2010 the $100,000 income limit is eliminated. And, more better, those who convert existing traditional IRA accounts to ROTH in 2010 can elect to spread the tax cost over two years – 2011 and 2012.

Because of this, many taxpayers with excess AGIs have been making non-deductible contributions to traditional IRAs for the past few years, planning to convert the accounts to ROTH in 2010 and being taxed only on the minimal income earned on the accounts. These individuals had never contributed directly to traditional IRAs in the past.

One such taxpayer – let’s call him Al - had made a total of $25,000 in non-deductible contributions over the years to an account which currently has a market value of $29,000. This taxpayer plans to convert the $29,000 to a ROTH in January 2010, expecting that only the $4,000 in earnings would be taxed, and this tax spread over two years.

But, as we shall see, this taxpayer will fall into the ROTH IRA Conversion Trap.

What we all have forgotten to remind you when discussing this issue is the way one calculates the taxable portion of a ROTH conversion.

The calculation, done on Form 8606, takes into effect all accounts with IRA in the name, and the “basis” in all accounts with IRA in the name, regardless of the source of the monies in the account. If you have in the past rolled over the balance in an employer 401(k) plan to an IRA when changing jobs that rollover IRA account is an IRA account, and it must be added to the IRA account to which the non-deductible contributions were made when doing the calculation of the taxable portion of the ROTH conversion.

Let us say that Al’s rollover IRA account has a balance of $425,000 on 12/31/2009. Because the money in this account came from employee pre-tax contributions to a 401(k) plan, Al has no “basis” in this account. He was not planning to convert this account to a ROTH IRA because then he would have to claim $425,000 in taxable income.

But, even though Al is only converting the $29,000 IRA account with a $25,000 basis, when doing the calculation the total balance of all IRA accounts will be $454,000 with a total combined “basis” of only $25,000.

Here is how the taxable amount is calculated. You divide the $25,000 combined basis by the $454,000 combined balance and come up with 5.506%. Only 5.506% of the $29,000 conversion can be excluded from tax. $29,000 x 5.506% = $1,597. Al will need to pay tax on $27,403 ($29,000 less $1,597) - and not the $4,000 on which he was expecting to pay tax!

So, as I advise in most cases, before you convert anything to a ROTH IRA be sure to work up the numbers with your tax professional first!



JoeTaxpayer said...

Excellent point. When I hear people talk about opening an new IRA each year, I tell them "You have one IRA, it just happens to be spread over multiple accounts, and possibly contains some post tax money in it."
This issue is related to whether one wants to transfer their ex-employer's 401(k) to an IRA which gets them into the situation you discuss. By leaving it in the 401(k) either at old or new employer, it's not in the IRA mix.

CH said...

Wow. This is a very important distinction. Interesting that it isn't getting much press with all the Roth conversion coverage.

(Unrelated question: Why do you capitalize "ROTH"? I was under the impression it was a name, not an acronym. Is this incorrect?)

Robert D Flach said...


Yes, the Roth in ROTH refers to a person.

Don't know why I capitalize it. It just looks better that way.


Parag said...

The bottom line is that now is the time to execute your Roth IRA conversion, especially if you can withstand the tax you will incur. This opening will probably not last forever, as Congress will no doubt find some reason in the future to bar higher incomes from access to Roth accounts again. For now, however, the road to Roth is clearly marked for everyone.