Death & Taxes

Roth IRA, Part II

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By Roy Lewis

In Part I, we reviewed Roth IRA basics. Now let's look at the major issues surrounding converting from a regular IRA to a Roth IRA.

Conversion From a Regular IRA to a Roth IRA

Conversion Must Be Qualified: As most of you know, a conversion from a regular IRA to a Roth IRA is possible if certain conditions are met. First, the conversion must be qualified. The term "qualified rollover" can get a little complex, but it is basically a rollover that is done within the 60-day rollover time limit, and is not in violation of the "one-year" rollover rules. For additional information regarding qualified rollovers, check out my other articles on this very issue -- IRA Rollovers vs. Transfers -- Part I, Part II, and Part III.

Adjusted Gross Income (AGI) Limitations: Assuming you meet the requirements of the "qualified" distribution rules, you still have one other hurdle to clear -- the Adjusted Gross Income limitations. The law states that if your AGI is greater than $100,000, you cannot convert from a regular IRA to a Roth IRA.

This $100,000 limitation applies not only to single filers, but also to married people filing jointly and head-of-household filers. Furthermore, don't think you can beat the AGI limitations by filing a married-separate tax return. You can't. The law specifically states that if you are a married taxpayer filing a separate tax return, you cannot convert your regular IRA to a Roth IRA regardless of your AGI.

And, remember that the AGI limitations are computed without regard to the amount of the conversion. An example here might be appropriate.

Example: Jack, a single person, has an AGI of $75,000. Jack also has a regular IRA in the amount of $60,000 that he converted to a Roth IRA. For AGI limitation purposes, Jack's conversion threshold is $75,000 (the amount of his "normal" AGI, without regard to the conversion amount), not the total of his "normal" AGI and his "conversion" amount. Jack's AGI for computing the income taxes he has to pay will be adjusted to reflect the "conversion" amount if he decides to make this conversion, but that's an issue that we'll discuss in detail a little later.

Note: So, what if you made a Roth conversion this year and now find that your AGI for the year will exceed the $100,000 limitation? First, don't panic. You have the ability to "recharacterize" your Roth IRA back to a regular IRA without penalty if you follow a few simple steps. Second, we'll be talking more about Roth IRA recharacterization rules and issues, so check out the other parts to this series.

Conversion Taxation Issues

OK you've decided that you can make a Roth conversion. Now you need to know more about the tax issues involved so you can decide if you should or want to make the conversion.

In effect, funds you convert from regular IRAs to the Roth IRA that would have been taxable under any other type of distribution, will be subject to income tax at your normal tax rate plain and simple. If all your prior IRA contributions were deductible (i.e., you deducted them from your taxable income, so you haven't yet paid income taxes on the money), the total amount of the conversion (the contributions and any earnings on that money) will be subject to income taxes.

If part of your IRA consists of prior nondeductible contributions, that portion will not be taxed again at the time of the conversion. But, any earnings on those prior nondeductible contributions will certainly be subject to tax.

And, if your IRA was funded by a prior rollover from another qualified pension plan (such as a pension/profit-sharing plan, 401(k) plan, 403(b) plan, Keogh plan, SEP plan, etc.), all of the funds will be taxable at the time of the conversion.

And, if you do decide to convert a traditional IRA to a Roth IRA, you'll need to complete IRS Form 8606 to report your "basis" (if any) in your traditional IRA, and to report your taxable conversion income to the IRS. So, if there is a conversion in your future, make sure to review IRS Form 8606 and the associated instructions.

Roth Conversion Income Spread: You may have heard that you can "spread out" reporting and paying income taxes on your Roth IRA conversion income over a number of years. And, that was true for any conversions made on or before December 31, 1998. But, since 1998 has long come and gone, so has your ability to spread any conversion income. You'll be responsible for the taxes on the total conversion income in the year of conversion. Period.

This Roth IRA conversion income will impact any and all tax limits and thresholds that are based on your AGI except for any current or future Roth contribution and/or conversion issues. For example, your ability to deduct medical expenses (7.5% AGI floor), your ability to claim miscellaneous deductions (2% AGI floor), whether you have to pay taxes on Social Security income (based on AGI), passive loss limitations (based on AGI), and many other tax provisions that use AGI as a guidepost will be impacted -- in some cases, severely impacted. So, this must all be taken into consideration when you decide whether you want to make a Roth IRA conversion at all.

No Penalty: Because the conversion is "qualified," the 10% penalty for an early withdrawal from an IRA account will not be imposed. In effect, the conversion can be made without paying the 10% IRA early withdrawal penalty. But, should you decide to remove these converted funds from the Roth IRA "early," you may be subject to a penalty. We'll discuss the penalty issue in detail in Part III.

Confused? No need. Let's continue with the example of Jack and his conversion.

Example: Jack's AGI is $75,000, and he made a $60,000 conversion from his regular IRA to a Roth IRA this year. So, now Jack's AGI for income tax purposes will be $135,000 (his regular AGI of $75,000 plus all of his conversion income of $60,000).

Jack will not be hit with a 10% early withdrawal penalty on the amount of the IRA converted to the Roth IRA (assuming Jack keeps his nose clean and doesn't take the funds out of his Roth IRA "early").

Finally, as noted above, all of the tax issues that use AGI for a benchmark (except Roth contributions and conversions) will now be based on Jack's new AGI of $135,000 for this tax year. So, his medical threshold is 7.5% of $135,000. His miscellaneous itemized deduction threshold is 2% of $135,000. And, any other issues using AGI as a benchmark (except for Roth IRA contribution or conversion issues) will be based on this new $135,000 AGI.

Jack decided to pay more tax dollars to Uncle Sammy right now. In effect, Jack is trading tax dollars now for the tax-free status of the Roth earnings in the future. Is that appropriate? Perhaps for Jack, based on his personal situation, the answer is yes. But, it is not necessarily appropriate for everyone. In fact, for some people, converting a regular IRA to a Roth IRA might actually cost them additional tax dollars in the long run.

That is why the Roth IRA conversion debate has become very heated. The decision to make this conversion is very personal, based on personal status, goals, age, intentions, etc. Therefore, the "to convert or not" question can only be answered by you, based on your personal financial, estate, and tax situation.

You can find Roth IRA conversion "calculators" all over the Web to help you with your decision (test several or read reviews first to make sure the calculator you use matches your personal situation best -- not all calculators are created equal). We have two useful calculators in our Retirement area to take you through the decisions about "Which is better: Regular IRA or Roth IRA?" and "Should I convert my IRA into a Roth IRA?" so feel free to use those as well.

You can also check out other sites that deal with Roth conversion decision issues. Two of the very best include the Fairmark tax site and the Roth IRA site. Before you make your final decision, you should take the time to read what these sites have to say about the pros and cons as well as their reviews of various calculators.

In Part III, we'll look at distributions from a Roth IRA, and what impact those distributions could have on your personal tax situation.
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