Roth IRA Conversion: What a Long Strange Trip It’s Been

Roth IRA Conversion

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?

7 Responses to “Roth IRA Conversion: What a Long Strange Trip It’s Been”

  1. Anonymous

    I am doing this as well. I have a large deductible SEP which is my problem. I need to get it out of the IRA “pot” so that I can then convert non-deductible IRAs (my traditional and my wife’s traditional). (We have a deductioble rollover IRA as well, but it doesnt have much in it).

    I have a 403(b) that allows Fidelity funds as an investment option, and it accepts rollovers. So I am going to roll my SEP into the 403(b). I was going to open up the solo 401K as you did, but then that would have to be my self-employment retirement plan and it is not convertible to Roth money. By using the 403(b), I can keep a SEP open for self-employment money and convert it every year.

  2. Anonymous

    We converted my wife’s 4o3(b) to a Traditional IRA, then converted the Traditional IRA to a Roth IRA. All the contributions were pre-tax so we will be responsible for the taxes but the balance is small enough for us to handle on this years taxes, but will probable mean we won’t get any tax refund, might end up owing a very small amount, but the tax-free gains in the Roth are worth it.

  3. Anonymous

    I have a Roth IRA that I haven’t fully funded in the past few years because of income limitations. So all I have to do is create a non-deductible Traditional IRA and convert it to a Traditional IRA? Is that right??? Dang it…

  4. Anonymous

    What if what you have in a traditional IRA is lower than what you contributed and some of those contributions were non deductible?

    Example for easiness

    $10k in trad IRA contributions
    $1k of that was non deductible
    Value now $9k

    So when converting all on the value now, would only $8k be taxable, $9k, value minus $1k non deductible contributions

    or would it be $8100 taxable, 1k/10k = 10% of contributions already taxed, so only 10% of 9k being transfered is not taxed?

  5. smith18: Try contributing it to your IRA, but to a different fund. IIRC, Vanguard handles “accounts” in a funny way, with each fund having a separate account number within your IRA. So while you can’t invest in the same fund that you sold, you should be able to get the money into the IRA in a different fund (money market if nothing else). Also note that you have until April 15th to contribute for 2010.

  6. Anonymous

    One watch out that got me on the conversion: my traditional IRA (I’m above the Roth income requirements) that I had been contributing to for tax year 2010 was a Vanguard mutual fund. I am $400 short of contributing the $5000 annual limit. When I attempted to pay in this remaining $400 I found out I was locked out. Reason being is that when I converted half of my traditional IRA into my ROTH IRA (trying not to convert the whole thing at once) Vanguard imposed a “frequent trading policy” rule on me. Since I sold, in this case transferred, shares out of the traditional IRA account I cannot contribute any new dollars to the account for 60 days. They do this to protect against people day trading in and out of mutual funds.

    I had to figure out another way of accounting for the $400 into a traditional IRA so that I could then move it into a ROTH. Not impossible but definitely a pain and added time.

    Simply: If you transfer shares out of a mutual fund make sure they do not have a rule that puts a time clock until you can contribute again. The best bet is to have contributed your entire annual amount prior to transferring into a ROTH.

  7. Anonymous

    Uncanny! I just did mine not 20 minutes ago! It wasn’t much…I had a 401(k) with an old employer that I transferred to a Rollover IRA after I left them to go back to school. Since I have the option to split my tax payments on the conversion between two years (I might not exercise the option and pay it all in 2011) I pulled the trigger.

    We’ll see what all the paperwork looks like in February (when I do my taxes), but with E*Trade it just took a few clicks and about 5 minutes. 100% of my Rollover IRA was taxable, and I will be paying taxes out of pocket so that there is actually a potential gain on converting my meager $1450. Nice thing is there won’t be much (if any) tax to pay on returns!

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