2010 Roth IRA Conversion Rules

What are the 2010 Roth IRA conversion rules?

You've probably heard a lot about the changes set to take effect in the near future.

But how do they impact you?

In 2010, the biggest change comes from the expiration of the $100,000 adjustable gross income (AGI) limit on Roth IRA conversions. In effect, this change enables anyone (regardless of income) to...

• Convert to a Roth IRA, and
• Contribute to a Roth IRA

Why is this such a big deal?

Because under the current rules, high income earners are prohibited from doing either. But as you'll see, all that's set to change...

AGI Limit For Roth Conversions

Under current IRS rules, you can only perform a Roth IRA conversion if your adjustable gross income (AGI) is $100,000 or less.

For instance, let's say you have $80,000 in a Traditional IRA, and you earn $150,000 per year. Under the current rules, you're out of luck if you want to convert your Traditional IRA to a Roth IRA.

But the new 2010 Roth IRA conversion rules change all that.

How?

By eliminating the $100,000 limit.

That's right...

As of 2010, the $100,000 limit on Roth IRA conversions simply disappears!

That means anyone, regardless of income, can perform a Roth IRA conversion.

For example, let's say you have a 401k you want to convert to a Roth IRA, but you earn $341,000 per year. Under the current rules, your income is too high to perform a conversion because it's higher than $100,000.

But under the 2010 Roth IRA conversion rules, you're able to convert because the $100,000 limit is no longer in effect.

Paying Your Conversion Tax Bill

So once you convert, then what?

Normally, when you incur a tax liability from a Roth IRA conversion, your tax bill is due in the same tax year in which you made the conversion.

But the 2010 Roth IRA conversion rules provide you with a one-time exception to this rule.

For the year 2010 only...

If you perform a Roth IRA conversion, you have the option of paying 50% of your tax bill in 2011 and the remaining 50% in 2012.

For instance, let's say you have a Traditional IRA valued at $200,000. Since you funded the account with deductible contributions, it's fully taxable, and your current income tax rate is 25%.

If you convert your Traditional IRA to a Roth IRA and take advantage of the 2010 IRS tax deferral, you owe nothing in conversion taxes for the year 2010. However, in 2011, you owe taxes on the first 50% of your conversion ($100,000). At 25%, that means you owe $25,000 in conversion taxes for the year 2011.

And when 2012 arrives, you owe taxes on the second half of your conversion ($100,000). Assuming the same 25% tax rate, that means you owe $25,000 in conversion taxes for the year 2012.

So, in total, you end up paying $50,000 in taxes over the course of three tax years instead of paying $50,000 in taxes the year in which the conversion took place. And spreading your tax bill over a longer period helps ease the pain of such a large bill.

However, if you choose to take advantage of this option, you need to be aware of one potential pitfall.

Since your tax bill is calculated by applying your current income tax bracket to the amount of your conversion, you could end up owing more in taxes if your income pushes you into a higher tax bracket in 2011 or 2012. So tread carefully...

For example...

Let's imagine the same scenario as before.

You have a Traditional IRA valued at $200,000, and your current income tax rate is 25%.

You convert your Traditional IRA to a Roth IRA and take advantage of the 2010 IRS tax deferral, pushing your tax liability forward to the years 2011 and 2012. In 2011, the bill comes due on the first 50% of your conversion ($100,000). At 25%, you pay $25,000 in conversion taxes for the year 2011.

But in 2012, you receive a raise at work which bumps you into the 35% tax bracket. With the tax bill due for the second half of your conversion ($100,000), you now owe 35% instead of 25%, meaning you now owe $35,000 in conversion taxes for the year 2012.

In this case, it doesn't matter that you were in the 25% tax bracket when the conversion took place. What matters is your tax rate for the year in which you pay the conversion taxes.

So don't automatically assume the tax deferral provision of the 2010 Roth IRA conversion rules is the right move in every situation. If you're not careful, it could end up costing you in the end.

Current Roth IRA Income Limits

The 2010 Roth IRA conversion rules open the door for anyone to convert to a Roth IRA regardless of income, but...

The door remains closed for high income earners when it comes to making new contributions.

For example, the 2009 IRS limits for making a Roth IRA contribution are:

• $176,000 if you're married filing a joint tax return.
• $10,000 if you're married filing a separate tax return and lived with your spouse for any part of the tax year.
• $120,000 if you're single, head of household, or married filing separately and did not live with your spouse for any part of the tax year.

While these limits adjust on an annual basis, the limits themselves remain intact for the 2010 tax year and future tax years as well.

So even though 2010 provides high income earners with a once in a lifetime opportunity to convert, making new contributions to a Roth IRA remains out of the question.

Or do they?

Fortunately for you, the 2010 Roth IRA conversion rules open the door for anyone to make new contributions to a Roth IRA, regardless of income!

How's that?

Through use of a Traditional IRA and the conversion process...

2010 Roth IRA Contributions

If you're ineligible to make a Roth IRA contribution because you earn too much, the 2010 Roth IRA conversion rules provide you with a golden opportunity.

How?

Here's how...

While IRS income limits also restrict your ability to make Traditional IRA contributions, those limits only apply to deductible contributions, NOT non-deductible (after-tax) contributions.

So if you're ineligible to make contributions to a Roth IRA, but you still want to, make non-deductible contributions to a Traditional IRA instead. Then, in 2010, when the $100,000 income limit on making a Roth IRA conversion disappears, you're free to convert your Traditional IRA to a Roth IRA, and...

Presto!

While it wasn't a direct contribution to a Roth IRA, the end result is still the same. You just made a contribution to your Roth IRA.

Do you see now why the 2010 Roth IRA conversion rules effectively eliminate the Roth IRA income limits?

If you earned too much to open and contribute to a Roth IRA in the past, 2010 marks a major change. Not only are able to perform a Roth IRA conversion, but you're free to effectively contribute to a Roth IRA by making non-deductible Traditional IRA contributions and then converting to a Roth IRA.

Need an example?

Let's say you're 40 years old and single with a $300,000 annual income. Under IRS rules, you're prohibited from making a direct contribution to your Roth IRA.

However, you CAN make up to $5,000 in non-deductible contributions to a Traditional IRA. And once the income restriction on Roth IRA conversions disappears in 2010, you can convert your Traditional IRA to a Roth IRA.

Since you made your original contributions with after-tax dollars, those funds are NOT subject to income taxes as a result of the conversion process. So, ultimately, you end up with $5,000 in your Roth IRA as a result of making non-deductible Traditional IRA contributions and then converting to a Roth.

And remember, as long as the 2010 Roth IRA conversion rules remain in effect, you can continue to do this on an annual basis. It isn't a one-shot deal for 2010.

Unless Congress intervenes, the $100,000 limit on Roth IRA conversions expires indefinitely, not just for the year 2010.

So unless, or until, a new law is put on the books, you're free to enjoy the benefits of contributing to a Roth IRA, regardless of how much money you make...

Conclusion

The 2010 Roth IRA conversion rules significantly alter the retirement planning landscape.

Because of the expiration of the $100,000 income limit on Roth IRA conversions, high income earners are no longer stuck on the outside looking in. The full benefits and advantages of a Roth IRA are now available to everyone regardless of income.

So if you've found yourself in the enviable position of earning too much to contribute to a Roth IRA, 2010 is the year you've been waiting for...

By making non-deductible Traditional IRA contributions and converting to a Roth IRA, you're able to effectively make Roth IRA contributions.

So take advantage of the opportunity afforded by the new 2010 Roth IRA conversion rules and get yourself a Roth IRA!

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