Doing a Roth IRA Conversion? – Leave the Door Open

You’re standing on the edge of the 10-meter diving platform ready to take the plunge into Roth IRA conversion waters, about to transfer 100% of your traditional IRA to a Roth IRA. Before you take that final step, there’s one more thing that you should consider if you’re still working or planning on working in the future and your income exceeds certain limits.

If you’re converting your entire traditional IRA to a Roth IRA, it doesn’t have to be, and in many cases shouldn’t be, the last Roth IRA conversion that you will do. In 2010, if you’re single and your modified adjusted gross income (“MAGI”) exceeds $120,000 or if you’re married and your MAGI exceeds $177,000, you’re prohibited from making direct contributions to a Roth IRA. It’s important to keep in mind that if your income doesn’t exceed these limits and you make a contribution to your Roth IRA, the maximum allowable amount is currently $5,000 or $6,000 if you’re 50 or older, and, furthermore, your contribution isn’t deductible.

While your income may limit your ability to make direct contributions to a Roth IRA, you may still make indirect contributions via a two-step process. In order to implement this strategy, you need to have a traditional IRA account in place. I recommend to all of my working clients who are considering full conversion of their traditional IRA’s to Roth IRA’s to keep one of their traditional IRA accounts open by leaving $1,000 in it. If you do this, even though you may be transferring 99% of your traditional IRA to a Roth IRA, you’re technically doing a partial, vs. a full, Roth IRA conversion.

Assuming that your income exceeds the specified deductible IRA contribution limits which in 2010 are $66,000 if you’re single and $109,000 if married, step one is to make a nondeductible IRA contribution to your traditional IRA account. The maximum allowable traditional IRA contribution, whether it is deductible or nondeductible, is identical to the maximum allowable Roth IRA contribution limit: $5,000 or $6,000 if you’re 50 or older.

Once you’ve made your nondeductible IRA contribution, you may immediately implement step two. Given the fact that, beginning in 2010, there are no income limitations in connection with converting traditional IRA accounts to Roth IRA accounts, step two is to complete your financial institution’s Roth IRA conversion form requesting transfer of the amount that you just contributed to your traditional IRA to your Roth IRA account. Once again, this will be a partial conversion since you generally want to leave funds in your traditional IRA account in order to keep it open for potential future contributions.

Although you have until April 15th to make an IRA contribution for the preceding year, it’s a good idea to execute this two-step process at the beginning of each year assuming that funds are available. This will get you in the habit of making sure that you implement this strategy each year, and, if done consistently over a number of years, can substantially add to the value of your Roth IRA account.

Financial Planning Roth IRA

Remember Your IRA Basis Scorecard When Planning Roth IRA Conversions

Most people who sell assets are familiar with the income tax concept of “basis.” Basis, in its simplest form, is essentially what you pay for something. When you sell an asset, you’re not taxed on the sales proceeds. Instead, you pay tax on the difference between your net sales proceeds and your cost basis. Net sales proceeds is equal to gross sales proceeds reduced by any selling expenses. Cost basis is equal to purchase price plus increases to the purchase price less accumulated depreciation or amortization. Basis, therefore, reduces the amount of otherwise taxable gain.

The concept of “basis” also applies to traditional IRA’s. When you make a contribution to a traditional IRA, your contribution is either deductible, partially deductible, or nondeductible depending upon (1) whether you’re an active participant in a qualified retirement plan, (2) the amount of your modified adjusted gross income, and (3) your tax filing status. To the extent that any portion of your IRA contributions are deductible, they aren’t credited with any basis. Nondeductible IRA contributions, on the other hand, are counted as, and increase, traditional IRA basis.

So what’s so important about basis when it comes to traditional IRA’s? As stated above, basis reduces the amount of otherwise taxable gain. When might you have taxable gain with IRA’s? Unlike assets which can result in a taxable gain when you sell them, traditional IRA’s can result in taxable gains when you take distributions from them. As we’ve learned from previous blog posts, a Roth IRA conversion is, in essence, an IRA distribution.

Similar to assets whereby you’re taxed on the difference between your net sales proceeds and your cost basis, with traditional IRA’s, you’re taxed on the difference between the value of your distribution and your basis in the distribution. How do you know what your basis is in your IRA? Keeping in mind that IRA basis originates from nondeductible IRA contributions, you need a way to keep track of your nondeductible IRA contributions. IRS has provided us with this ability with Form 8606 – Nondeductible IRAs. Form 8606 is your scorecard for keeping track of your traditional IRA basis.

Form 8606 is required to be filed with your tax return in any year that you make nondeductible contributions to a traditional IRA. In addition to reporting the amount of your current year’s nondeductible traditional IRA contributions on line 1, you are required to report your total basis in traditional IRAs on line 2. Total basis in traditional IRA’s represents your cumulative nondeductible IRA contributions reduced by any previously used basis.

Since Form 8606 isn’t required to be filed every year, it’s easy to forget about basis when calculating the amount of taxable IRA distributions, especially if it’s been a while since you’ve made nondeductible contributions to your traditional IRA and you haven’t retained copies of all of your tax returns. This can be especially problematic if you haven’t used a professional income tax preparer to prepare your income tax returns in all of the years that you’ve made nondeductible traditional IRA contributions or if you’ve changed tax preparers over the years. Tracking IRA basis can be further complicated to the extent that the basis in your traditional IRA is different for federal vs. state income tax purposes as a result of state vs. federal deductible IRA calculation differences such as has been the case in California.

If you’re considering doing a Roth IRA conversion, don’t forget about Form 8606 – your traditional IRA basis scorecard. It will reduce the amount of your taxable Roth IRA conversions and, in turn, will reduce the amount of income tax you will otherwise pay.


Two Steps to a Nontaxable IRA for High Income Individuals

If your goal is to contribute on a regular basis to a nontaxable investment account without investing in low-yielding tax-free municipal bonds from which you can take nontaxable distributions beginning at age 59-1/2 and assuming you can live with the annual contribution limits, IRS has provided you with this opportunity. Depending on the amount of your income each year, you will be able to achieve your goal in either one or two steps.

In 2010, if your modified adjusted gross income (“MAGI“) is less than $105,000 if you’re single or $167,000 if you’re married filing a joint return, you can contribute up to $5,000, or $6,000 if you’re 50 and over, to a Roth IRA assuming that you receive taxable compensation of at least these amounts. Your Roth IRA distributions will be nontaxable provided that you (a) don’t take any distributions for at least five years after you make your first Roth IRA contribution and (b) wait until you reach age 59-1/2 to take your distributions.

What if your MAGI exceeds the above thresholds and you’re therefore not eligible to make Roth IRA contributions, how do you achieve the goal stated at the outset of this blog? It can be done, however, you will need to do it in two steps as follows:

  1. Make nondeductible IRA contributions.
  2. Convert nondeductible IRA contributions to a Roth IRA.

Step 1: Make Nondeductible IRA Contributions

Assuming that your MAGI exceeds the stated thresholds for making Roth IRA contributions, you can make deductible contributions to a traditional IRA assuming that you aren’t an active participant in an employer-sponsored retirement plan. If you do this, however, 100% of the withdrawals from your IRA will be taxable. If, on the other hand, you’re an active participant in an employer-sponsored retirement plan, you can make non-deductible IRA contributions up to $5,000 or $6,000 if you’re 50 and over to a traditional IRA assuming that you receive taxable compensation of at least these amounts.

When it comes time to taking distributions, the good news is that the portion of your distributions representing contributions to your IRA will be nontaxable. If you leave your nondeductible contributions in a traditional IRA, you will not achieve your goal of nontaxable distributions, however, since the portion of your distributions representing earnings will be taxable as ordinary income. This could be substantial assuming you consistently make nondeductible maximum-allowable contributions over many years.

Step 2: Convert Nondeductible IRA Contributions to a Roth IRA

There is a second step that you need to follow religiously each year after making your nondeductible IRA contributions if you want 100% of your IRA distributions to be nontaxable. Immediately after making your nondeductible contributions to your traditional IRA account, you need to convert 100% of your contributions to a Roth IRA. Once your traditional IRA funds are transferred to your Roth IRA, none of the distributions from your Roth IRA will be taxable, including earnings, provided that you don’t take any distributions for at least five years after you make your first Roth IRA contribution and you wait until you reach age 59-1/2 to take your distributions.


As an example of the potential power of using this strategy over an extended period of time, including illustrating the differences in taxation between deductible traditional IRA’s, nondeductible traditional IRA’s, and Roth IRA’s converted from traditional nondeductible IRA’s, please see Projected IRA and Taxable IRA Amounts spreadsheet. The spreadsheet was prepared using the following assumptions:

  • Maximum annual contributions to nondeductible traditional IRA’s from age 40 through age 69 on January 1st of each year
  • Immediate conversion of nondeductible contributions to Roth IRA
  • Maximum allowable annual contributions beginning at $5,000 increased by $500 per year every five years with additional $1,000 per year “catch-up” contributions beginning at age 50
  • Earnings at 5%
  • No withdrawals before age 70

Given the foregoing assumptions, per the spreadsheet, the projected value of the Roth IRA at age 60 would be $446,773, none of which would be taxable. Assuming that the nondeductible IRA contributions remain in a traditional IRA and aren’t converted to a Roth IRA, 100% of the projected earnings of $239,273 would be taxable. Finally, with a traditional deductible IRA, 100% of the projected contributions and earnings of $207,500 and $239,273, respectively, for a total of $446,773 would be taxable.

As you can see, it’s possible to accumulate a sizeable nontaxable nest egg if you start early and commit to making regular annual contributions. As an added bonus, because your funds are sitting in a Roth IRA, in addition to your withdrawals being nontaxable, they’re also not subject to the required minimum distribution rules.