Roth IRA Conversion Rules Changing – Have You Reviewed Your Tax Plan – Part V

October 21, 2009

This is final part of a five part series of posts related to Roth IRA Conversions and the rule changes that go into effect on January 1, 2010. As mentioned in prior posts in this series regarding Roth IRA Conversions, I will explain the rules around Roth IRAs, as well as what the recent changes in the law means. I will also provide you with some reasons to convert, as well as some reasons not to convert. In addition, my final post will include some tax planning tips around the Roth IRA.

For other posts in this series, please visit:

Part I: What is a Roth IRA? What is changing about Roth IRA Rules?
Part II: Reasons to Convert to a Roth IRA.
Part III: Reasons NOT to Convert to a Roth IRA.
Part IV: Planning Ideas around Converting to a Roth IRA
Part V: Planning Ideas – What is the Pro-Rata Rule?

In this post, I will review a few more tax planning considerations related to Roth IRAs. It is important to keep in mind that everyone’s situation is different and that these ideas may or may not apply to you. You should sit down with your tax professional and do proactive tax planning prior to doing anything.

Can’t Afford to Convert?  If you are like many taxpayers, you look at the cost of conversion and it is overwhelming.  The good news is that you don’t have to do the entire conversion all at once.  You can convert a small portion of your IRA each year over a several year period – depending upon what you can afford to pay in additional taxes for the year of conversion.  In addition, this allows you to sit down with your tax planner and find out the magic amount that you can convert this year without being pushed into a higher tax bracket.  By planning this conversion out over several years, you may be able to lower the taxes that you pay on the conversion, as well as spread it out over many years.

The Pro-Rata Rule.  Wouldn’t it be great if you could choose to convert your nondeductible contributions and keep the contributions that you deducted as traditional IRAs – thus paying very little, if any tax?  Sorry, but that is where the Pro-Rata Rule comes into play.  When determining the amount of your conversion that was from deductible contributions and the amount that was from non-deductible contributions, the IRS looks at all of your IRAs.  You must add the value of all of them together, then divide by the nondeductible contributions, and this will give you the percentage of any conversion that you make that is tax- free.    This prevents you from converting only your nondeductible contributions.  The good news is that you may be able to use a loophole – the 401(k) loophole below.

401K Considerations.  Balances in 401(k) accounts are not included in the calculations for the Pro-Rata Rules.  In addition, some employer 401(k) plans allow you to rollover your traditional IRA into the plan.  By doing so, it can allow the taxpayer to exclude some or all of their deductible contributions from the calculation.  This will result in a higher percentage that can be converted to a Roth IRA tax free.  In the event that a taxpayer that plans to do a conversion has already rolled their 401(k) into a traditional IRA, they may wish to consider rolling it back to a 401(k) if their employer plan allows.

Due to this Pro-Rata Rule, it is not usually recommended that you convert your 401(k) to a traditional IRA until after you are through with any Roth IRA conversions that you plan to do.  The exception to that would be if you wanted to convert the 401(k) balance to a Roth IRA as well.  Even if you do, it is probably a good idea to sit down with your tax planner to make sure that you structure the timing of the conversions in a manner that will maximize your tax savings.

Minimum Distributions.   As mentioned several times during this series of post, if you are over the age of 70 1/2 and you are taking Required Minimum Distributions (RMDs) from your traditional IRA or workplace plan, you can not include the current years RMD in the conversion amount.  You must pay the necessary tax on that RMD, and then you can convert the remaining balance.  (Note:  There are no RMDs for 2009 because Congress passed legislation to waive them due to the down market – fearing that they would wipe out many peoples retirement accounts.  RMDs are scheduled to resume in 2010.)

Donna Bordeaux, CPA with Calculated Moves

Creativity and CPAs don’t generally go together.  Most people think of CPAs as nerdy accountants who can’t talk with people.  Well, it’s time to break that stereotype.  Lively, friendly, and knowledgeable can be a part of your relationship with your CPA as demonstrated by Donna and Chad Bordeaux.  They have over 50 years of combined experience as entrepreneurial CPAs.  They’ve owned businesses and helped business owners exceed their wildest dreams.   They have been able to help businesses earn many times more profit than the average business in the same industry and are passionate about helping industries that help families build great memories.