Charles called into Newstalk 750 WSB today. He’s been putting away after-tax cash into his conventional IRA because he made too much money to contribute to a Roth IRA. He’s got $30,000 stashed there. He wanted to know if he can convert it to a Roth IRA even if he makes more than $150,000 per year.
Unfortunately, you can only earn $100,000 (adjusted gross income) or less to be eligible to convert the cash from the IRA to the Roth IRA. But on May 17, 2006, President Bush signed an Act into law that will do away with the income limits for the conversions starting in 2010. In 2010, you may convert any IRA into a Roth IRA no matter how much you make. And, you’ll be able to pay the taxes due half in 2010 and half in 2011.
Since Charles’ money is after-tax, he’d probably only pay tax on any earned income or pre-tax cash in the account. Here’s what Chet Burgess, an enrolled agent and owner of Brookwood Tax Service in Atlanta had to say:
The income limits for Roth IRA contributions and Roth conversions are determined by adjusted gross income (AGI). AGI is the number at the bottom of the first page of the Form 1040 and is computed BEFORE deductions and personalexemptions on page 2.
Several consumer finance publications have published articles following this year’s tax law changes urging people with AGI’s over the Roth contribution limit to make the maximum non-deductible contributions to a regular IRA for the next five years (2006 through 2010), then do a Roth conversion in 2010.
At least two of the articles told consumers that when they do the conversion in 2010, only the amount of earnings on their contributions will be taxable. One magazine cited an example, with a taxpayer making $4,000 annual non-deductible contributions over five years, totaling $20,000 of non-deductible contributions.
The taxpayer would have a $20,000 basis in the traditional IRA. Assuming a total of $5,000 in earnings within that IRA over the next four years would bring the total balance in the IRA to $25,000. If the full $25,000 balance is converted to a Roth, the taxpayer will pay tax at his top ordinary income rate on the $5,000 in earnings, but the $20,000 in contributions will be converted to the Roth tax-free.
As is often the case with tax law, it’s not that simple. The basic rule regarding taxation of Roth conversions, is that the ratio of taxable and non-taxable conversion amounts must be calculated using the total balances of ALL of the taxpayer’s traditional IRA’s. If the taxpayer has only the one IRA with the five years’ worth of non-deductible contributions, then the magazine articles would be correct.
However, suppose that taxpayer had also rolled over a 401(k) from a previous job into an IRA and that rollover IRA has a balance of $75,000. All the401(k) contributions were pre-tax, so the taxpayer has no basis or cost in the rollover IRA. The combined balances of both IRA’s totals $100,000. Since the taxpayer’s only non-deductible contributions are the $20,000 to the new IRA, his combined basis in both IRA’s is that same $20,000 or 20% of the combined total.
If the taxpayer converts the full $25,000 in his newer IRA to a Roth in 2010, only 20% of the conversion amount will be non-taxable. The other 80% or $20,000 (80% x $25,000) will be taxable at his top ordinary income rate.
I still firmly believe that the Roth IRA is an excellent tax-advantaged investment, especially for younger taxpayers (maybe under 50 or 55), so making the conversion can still save taxes over a span of several decades and provide tax-sheltered earnings even to the next one or two generations.
But taxpayers need to be aware of the rule requiring them to add up the combined balances of all their IRA’s and run the numbers carefully to ensure they make plans for the current tax bite before making a conversion.
Published: Jul 20, 2006