As of today, my Roth IRA conversion is complete. Those that have been following along are aware that this has been a rather complex process. Today, I wanted to summarize this all in one place in case anyone else is considering something similar.
Roth IRA conversion rules
For starters, the IRS changed the Roth IRA conversion rules in 2010. Prior to this year, there was an income limit for Roth conversions, but now that’s history.
In other words… As of this year, anyone can (effectively) contribute to a Roth IRA, regardless of how much money they make. If you’re above the Roth IRA contribution limits, simply make a non-deductible* contribution to a Traditional IRA and then turn around and convert it.
*Note: If you’re above the income limits for contributing to a Roth IRA, then you’re above the limit for deducting your Traditional IRA contributions.
Tax consequences for deductible contributions
If you’re converting deductible contributions, then you’ll have to pay income taxes on the amount that you convert. If, however, you do the conversion before the end of 2010, the you’ll have the option of deferring the tax burden into 2011/2012.
The biggest considerations when deciding whether or not to defer the taxes are: (1) whether or not you have the cash on hand to pay the IRS up front, and (2) how your future income tax bracket will compare to your 2010 tax bracket. If you expect to be in a higher bracket in the future, it might be best to go ahead and pay right now.
Just be sure that you don’t have to use some of your IRA money to cover the tax burden, as you’ll face a 10% penalty (in addition to the tax bite) if you take an early distribution to pay the taxes.
Tax consequences for non-deductible contributions
If all you have is a Traditional IRA filled with non-deductible contributions, then you’re golden. You’ve already paid taxes on these funds, so you’ll only have to pay taxes on investment gains beyond your initial contributions.
To get an idea of how much taxable income we’re talking about, simply subtract your total amount of non-deductible contributions from your account balance. Assuming that this amount is positive, you’ll have a tax liability.
Of course, if you’re contributing and converting all at once (basically using the Traditional IRA to funnel money into the Roth) there will be little to no tax liability, as there won’t be any time for your investment to grow prior to the conversion.
Tax consequences for more complex situations
For many of us, the situation is more complex in that we’ll have made both deductible and non-deductible IRA contributions in the past. Unfortunately, you can’t simply pick and choose the dollars that you want to convert.
Instead, the IRS looks at all of your IRAs (Traditional, SEP, and SIMPLE) as one big pot of money when determining taxable amounts. Here is an example to illustrate what I’m talking about:
You have a SEP-IRA with $5000 in tax deferred funds (deductible contributions + earnings) along with a Traditional IRA with $4000 in non-deductible contributions plus $1000 in earnings.
In this case, 40% of the holdings ($4k out of the $10k total) have already been taxed, so 40% of your conversion would be tax-free. This is true regardless of which account(s) the money actually comes from.
More details can be found here. The good news is that amounts in “qualified” plans such as a 401(k) or 403(b) are not included in this calculation.
Moving IRA money into a qualified plan
Since funds in a qualified plan are not subject to the tax calculation outlined above, one option for avoiding taxes when converting would be to move all of your non-deductible contributions into a qualified plan.
While some employer plans do accept rollovers, there are some pretty bad 401(k) plans out there. This, you might want to consider opening a Solo 401(k) where you’ll have full control of your investment options and rolling your money into that.
As it turns out, you’re allowed to “separate your basis” when doing this sort of rollover. In other words, you can pick and choose the dollars that go into the 401(k), meaning that you can move your deductible contributions but leave your non-deductible contributions behind. Pretty slick, huh?
This is exactly the process that I’ve been working through over the past month or so. While my SEP-IRA was at Vanguard, they don’t accept IRA to 401(k) rollovers, so I had to look elsewhere. In the end, I decided to go with a Fidelity Solo 401(k) plan.
The required steps were:
- Adopting the plan and opening an account (link)
- Rolling the Vanguard SEP-IRA into a Fidelity Rollover IRA (link)
- Rolling the Rollover IRA into the Solo 401(k) (link)
- Converting the non-deductible Traditional IRA into the Roth IRA (link)
As of about five minutes ago, I’ve made it through all the steps and am now just waiting for the final transfer (conversion) to go through. Whew. Are any of you readers doing something similar? Or is it just me?