The Complexities of Converting IRAs

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This week, Gail discusses the intricacies of IRAs, Roth IRAs and the conversion process.

Dear Gail —
My wife and I haven’t qualified for a deductible IRA contribution since that late 1980s. Over the past ten years, our income has ranged between $162,000—175,000, which means we haven’t been able to do Roths, either. I suppose the government considers us “rich,” but it doesn’t feel that way. With three kids and living in the Bay Area, it’s sometimes tough to make ends meet even though we both work full time.

We try to be diligent about saving for retirement, so each year we make non-deductible contributions to regular IRAs — our only option. Some years we’ve put the maximum amount in, but sometimes we contribute less.

I read your column and others about the tax legislation passed a couple of months ago and I’m wondering if I’ve got this right: When they do away with the income limit for converting to a Roth in 2010, I want us to convert our non-deductible IRA contributions. The way I figure it, since we already paid tax on this money, we won’t owe any additional tax when we do the conversion. What do you think of this idea?


Dear Larry-
Nice try. Really. I mean that. You’ve clearly been giving this a lot of thought. If only the math worked that neatly.

You are correct that the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA) which was signed into law at the end of May eliminates the income limit on Roth IRA conversions [Click here to read more about TIPRA]. This limit has been $100,000 ever since Roths were introduced in the late 1990s and it applies whether you are single or married. But in 2010, thanks to “TIPRA,” the income restriction is slated to disappear.

However, Ed Slott, a CPA and author of “Parlay Your IRA into a Family Fortune,” says even when that happens you can’t cherry-pick the IRA dollars you want to convert. He compares an IRA to a cup of coffee: The non-deductible contributions in it -- the ones made with after-tax money -- are the “cream” while the balance -- which consists of deductible contributions and all earnings -- is the “coffee.”

“Once you put the cream in the coffee, you can’t separate it,” says Slott. “Every drop you take out is part cream and part coffee.”

Which is a colorful way of saying that whether you convert all of your IRA or just a portion of it, the tax you’ll owe will be based on the percentage of ALL your IRAs that after-tax contributions represent.

To calculate this, you have to add up all the non-Roth IRAs you own. This includes traditional IRAs, SEPs, and SIMPLEs. -- not just the one containing the after-tax contributions.

Say you’ve got two IRAs: No. 1 contains only pre-tax (i.e. deductible contributions), plus the earnings on them. This is also where you rolled your 401(k) when you switched jobs. IRA No. 2 is where your after-tax (i.e. non-deductible) contributions went. Here’s how they looked as of the end of last year:

Whether you want to convert IRA #1 or IRA #2, both, or just a fraction of one, the first step is to calculate the after-tax portion:

After-tax Contributions / Total (non-Roth) IRA Assets

This tells you what portion of the converted amount will not be subject to income tax. In above example, this amounts to 14.3 percent:

$30,000 / $210,000 = .143 = 14.3%

Thus, if you convert IRA #2, you’ll owe income tax on all but $7,380 (14.3 percent x $60,000). Notice that despite the fact this IRA was funded with $30,000 in after-tax contributions, you’ll only get “credit” for $7,380.

However, when you take withdrawals or convert IRA #1, the same formula applies and a portion of that amount will not be taxable, even though it is entirely made up of pre-tax contributions.

“I hate non-deductible contributions because of the recordkeeping,” says Slott. But in light of the new law, he’s changed his mind and is advising people to “dump everything you can” into a traditional IRA so that when 2010 arrives, you’re ready to convert that to a Roth. Why? Because once in a Roth, all future earnings are tax-free .

To maximize the benefit of this, you will want to use non-IRA money to pay the taxes due on the conversion. So you might want to start setting aside money now for that purpose. Conversions made in 2010 get special treatment: You don’t have to pay taxes that tax year (unless you want to). Instead, the tax bill will automatically be split between 2011 and 2012.

While Congress would label that an “incentive” designed to induce you to convert, attorney Natalie Choate, who specializes in retirement plan distributions, calls the delayed tax payment “a cheap stunt for them to balance the budget.”

Cheap or not, it’s real. And it’s no less of an incentive than the ability to deduct the interest paid on your mortgage. Let’s face it: most taxes are designed to influence behavior.

Mark Luscombe is Principal Tax Analyst for CCH, a major provider of tax information and software. He makes an interesting point: By lifting the income limit on Roth conversions starting in 2010, TIPRA effectively eliminates the income limits on Roth contributions .

Under the law, if you are single, you are not eligible to make the maximum IRA contribution ($4,000 this year) to a Roth IRA if your “modified adjusted gross income” (MAGI) exceeds $95,000. You can make a partial contribution if your income falls between $95,000 -- $110,000. If you’re married, the ability to make a full contribution phases out between $150,000 -- 160,000.

These annual contribution limits have never been adjusted for inflation and they are not changing in 2010. But once you convert all of your existing IRAs, you can get around the income limits on Roth contributions by doing an IRA “two-step.”

Returning to the example above, let’s say you convert IRA #1 and IRA #2 in 2010. As a result, all of your non-Roth IRAs have been closed and the proceeds -- $210,000 -- now sit in a Roth.

Assuming your income that year exceeds the limit for both deductible and Roth IRA contributions, your only option is to make a non-deductible (after-tax) contribution to a regular IRA. For argument sake, we’ll assume this amount is $5,000.

Since there is no waiting period, the following day you convert IRA #3 to a Roth. Assuming it hasn’t drastically changed in value overnight, your non-deductible contributions will equal your total non-Roth IRAs.

After-Tax Contributions / Total (Non-Roth) IRAs = $5,000 / $5,000 = 100 Percent

Since the entire conversion amount consists of after-tax money, the conversion is completely tax-free. No additional tax is due. Afterwards, your IRA inventory looks like this:

IRA #1: $0
IRA #2: $0
IRA #3: $0
Roth IRA: $210,000 + $5,000 = $215,000

It’s annoying that we have to play games like this, but, hey, do you want a Roth IRA or not? Of course, there’s always the chance that Congress will wise up to this loophole and close it before 2010 comes around…. I’ll keep you posted.

Hope this clears things up,

If you have a question for Gail Buckner and the Your $ Matters column, send them to:, along with your name and phone number.