Managing a high-income Roth conversion

By Walter Updegrave, senior editor


(Money Magazine) -- Question: My wife and I are both over 50 and plan to convert $115,000 in traditional IRAs to Roth IRAs this year to take advantage of the one-year reprieve on income limits on conversions. Our question: can we each also make regular annual contributions to a Roth IRA this year? We earn about $100,000 a year combined, but we're worried that the $115,000 of taxable income we'll have to recognize because of the conversion will put us over the income eligibility limit for annual Roth IRA contributions. Can you clear this up for us? -- Bob, Souderton, Penn.

Answer: If nothing else, your question shows that there are just too many damn nitpicky rules for most people to get their heads around when it comes to taxes in general and retirement savings plans in particular.

walter_updegrave__2009b.03.jpg
Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005)

The complexity is frustrating enough in and of itself. But the bigger problem is that the ever-changing maze of regulations Congress has created makes it harder than it should be for people to save and plan for retirement.

But enough railing from me. Anyone interested in a more rational and streamlined system can take it up with the powers that be in DC. In the meantime, I'm happy to help you out on several Roth-related points.

Before I answer your question about annual contributions, however, I want to start by setting you straight on what you refer to as the "one-year reprieve" on the income limits related to Roth conversions. In fact, this year's elimination of the restriction barring people with modified adjusted incomes over $100,000 from converting a traditional IRA (or 401(k), for that matter) to a Roth IRA isn't just a one-year deal. The income test for conversions has been jettisoned, period.

So even though there's been a lot of hype about the fact that people with high incomes will finally be eligible to do Roth conversions this year, it's not as if they have only a one-year window. Of course, Congress could always change its mind and reinstate that or any other restriction in the future. But I know of no plans to do so.

As for your concern that by converting to a Roth IRA you and your wife may lose the chance to make annual contributions to Roth IRAs this year, you can rest easy there too.

True, converting a traditional IRA or 401(k) does create taxable income (although, if the conversion includes after-tax dollars, you won't be taxed on that amount, as this worksheet shows). But taxable income generated by the conversion itself does not count in determining whether you're eligible to make an annual Roth IRA contribution.

That's because the income limit for annual contributions is based not on taxable income but on your MAGI, or modified adjusted gross income. And when toting up your MAGI for Roth IRA purposes, you exclude conversion income.

So the $115,000 you're converting won't affect your eligibility. Assuming you and your wife file jointly and your MAGI is less than $167,000 this year -- which appears will be the case -- you each have the green light to contribute up to the $6,000 limit to a Roth IRA (the regular $5,000 max, plus a $1,000 catch-up contribution for people 50 and older). For the income requirements and contribution limits for married couples with higher MAGIs as well as for other types of filers, click here.

By the way, even if your income were above the MAGI limit, you and your wife could still effectively make annual contributions to a Roth IRA. You just contribute to a traditional deductible IRA (assuming you qualify or, if you don't, a nondeductible IRA (which anyone under the age of 70 1/2 with earned income can do) and then immediately convert that IRA to a Roth IRA. Remember, though, that if you already own other IRAs, you've got to take their balances into account when figuring the tax liability for the conversion, not to mention any investment gains your IRA may have generated between the time you opened it and you actually convert. For more on the ins and outs of determining the tax due on conversions, click here.

While we're on the subject of taxes, another thing to keep in mind is that if you convert in 2010, you can postpone the tax hit until you file your taxes for 2011 and 2012, which means, barring situations in which you might owe estimated taxes, you don't actually have to fork over cash for the tax hit until you file in 2012 and 2013.

One caveat: Some people mistakenly believe this provision means pay half that amount when you file your 2011 taxes and the other half when you file in 2012. Not so. It means you split the taxable income from the 2010 conversion into the 2011 and 2012 tax years, and then pay tax based on whatever tax rate applies to you in those years.

At this point, the tax rates that were in effect prior to 2001 are scheduled to return in 2011, which means the top rate would go back to 39.6% and the 10% bracket would be eliminated. Whether Congress will let this happen is anyone's guess. But if you think it's likely that you'll face a higher tax rate after this year, whether because we revert to the old higher rates or Congress enacts new tax increases or your income jumps and kicks you into a higher bracket, you may want to take the option of recognizing the conversion income this year and paying the tax.

As you're weighing this decision, remember that the taxable income stemming from the conversion itself may also push you into a higher bracket. You can mitigate, if not entirely eliminate, that effect by converting smaller amounts over time rather than doing the whole shebang at once.

Finally, I know you didn't ask about this...but since there's been such a hullabaloo about Roth conversions this year, I want to remind you that before you pull the trigger you should crunch the numbers to assure that a conversion makes sense in your case. If you haven't done that, you can do so by going to a Roth conversion calculator.

Whatever the numbers tell you, keep in mind that there's a good amount of uncertainty inherent in any projection, especially when taxes are involved. Which is why I'm a big advocate of tax diversification, or making sure you've got at least some of your nest egg in accounts that will receive different tax treatment.

In the same way you hedge risk by spreading your retirement savings among different types of assets, you can hedge your bets so that your entire nest egg isn't riding on just one tax scenario playing out.

Oh, and by the way, if after doing the conversion you decide it wasn't the right move -- you don't have the cash to pay the tax, your Roth account's value took a dive, whatever -- you may be able to take a mulligan. That's right, a provision known as a "recharacterization" allows you to reverse the conversion and, if you wish, reconvert later, assuming you meet the criteria.

In the welter of rules, restrictions and regulations governing Roths, this escape clause is one you'll definitely want to remember, just in case. To top of page

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