Due to our National Debt crisis and rightly so, most Americans believe an increase in income taxes, along with other tax increases and reductions in benefits is inevitable. As investors, we have a choice. Either we can complain about the taxes we pay or we can use the tax code to minimize the taxes we pay.
One such strategy is a Roth Conversion. Prior to January 1, 2010, you could only do a Roth Conversion if your Modified Adjusted Income was below $100,000. That restriction has been lifted and now anyone, regardless of income can do a Roth Conversion if you are an owner of a retirement account listed below:
- Traditional IRA
- SEP IRAs and Simple IRAs (early distribution penalty within first 2 years from Simple IRA)
- Employer sponsored retirement plan such as Thrift Savings Plan (TSP), 401(k)s,403(b)s, and 457 plans (as long as you are eligible)
The taxable amount of Roth Conversions is included in income in the year the conversion was done.
So, for example, if you converted $20,000 from a tax-deductible IRA, to a Roth in 2011, that $20,000 of income will be included in your 2011 taxable income. That seems pretty straight-forward.
Here is a hypothetical situation.
John has 3 IRA accounts. IRA #1 was funded with deductible contributions and has an account balance of $30,000. IRA #2 was funded with non-deductible contributions with an account value of $20,000, but the basis, the amount that was already taxed is $15,000. IRA #3 was funded from a 401(k) rollover, and has an account balance of $50,000.
John would like to take advantage of today’s known tax rate and convert some of his IRAs. He feels it would be best to convert IRA #2, since only $5,000 of that conversion would be taxable. But, if you are thinking that this is a pretty good idea, you are wrong!
The Internal Revenue Service will not allow you to “cherry pick” and convert the IRA with the highest basis. Instead you must follow the pro-rata rule and include all of your IRAs to determine what percent is taxable with this percentage being the same for any IRA you convert.
This is how it would work in the above example:
(1) Add up the taxable portion of all of John’s IRAs, which amounts to $85,000,
(2) Add the total of all John’s IRAs, which is $100,000, and
(3) Divide the taxable portion of the IRAs by the total account values of all IRAs to determine the pro-rata factor.
Here is the result: $85,000 / $100,000 = 85%.
Now, regardless of which IRA John converts, he will have to apply the 85% pro-ration factor to the amount that he is converting to determine the tax. If John converts IRA #2, he will have to multiply $20,000 by 85% and find that $17,000 is taxable, not $5,000.
Now, here is another example of a common mistake that can occur if you are not familiar with the rules for doing Roth conversions. Linda and Tom both work at GSA and are both going to retire on June 30, 2011. They also each have $300,000 in their TSP and each have an IRA worth $20,000, of which $15,000 was made with non-deductible contributions.
Would you believe that they are both thinking exactly alike and are planning to convert their IRAs to a Roth IRA this year? However, their strategies are a little different.
Tom has found an investment that he feels will provide a better income strategy with more flexibility than keeping his funds in TSP. He plans to roll over his TSP one month after he retires. He is concerned about future taxes and has made the decision to convert his IRA to a Roth before the end of the year.
Now, let’s move ahead to April 15, 2012. John is meeting with his accountant to get his 2011 tax return done by the end of the day. He is boasting to his accountant how well his IRA is doing since he rolled it over from his TSP account last year. He is also glad that he made the decision to convert his IRA to a Roth in 2011, and has $1,000 available to pay the tax from this conversion.
Tom came to the conclusion that his tax from the conversion would be $1,000 by the following calculation: IRA value $20,000, of which $15,000 was non-deductible contributions. The taxable amount of the conversion will be $5,000.
Tom’s tax rate is 20% so he multiplies 20% of $5,000 and believes the conversion will cost him $1,000. Tom fell to the ground when his accountant told him that he must add up all of his IRAs that he had in 2011, to determine the pro-ration factor. He tells Tom that the conversion will cost him $3,800.
This is how Tom should have done his calculation:
(1) Add the taxable portion of his IRA balances which is $305,000.
(2) Add the total of both of Tom’s IRA balances, which is $320,000, and
(3) Divide the taxable portion of the IRAs by the total account values of all IRAs to determine the pro-rata factor, which looks like this: $305,000 / $320,000 = 95%.
The pro-ration factor used on the Roth Conversion is 95%. $20,000 X 95% = $19,000, $19,000 X 20% (tax rate) = $3,800. Tom has to go home and tell his wife that because of his mistake, they will have to cancel their retirement celebratory cruise that they had planned on taking in September.
Linda also believes that there is a more suitable strategy for her TSP, but is advised not to roll it over to an IRA until 2012, since she is doing a Roth Conversion in 2011.
Let’s jump ahead to 2012. Linda rolls over her TSP in January. She is happy that she converted her Roth IRA in 2011, and plans to hold off on taking income until later in retirement to maximize on the tax free growth this account can provide. Linda also has set aside $1,000 to pay the tax on her Roth Conversion.
In her case, this is the correct amount. She only had the $20,000 IRA, of which $15,000 was already taxed. She had to include $5,000 of taxable income from the conversion done in 2011, and her tax rate was 20%. Linda did not have to include her TSP balance when she did her Roth Conversion in 2011 because the funds in her TSP did not need to be included. This is because she did her Roth Conversion in 2011, and is waiting until 2012 to rollover her TSP.
Forward proactive tax planning is needed to create a well balanced retirement plan. Roth Conversions can provide an enormous benefit to some people. However, it is critical to have a thorough understanding of the rules and tax reporting issues. The best strategy is to get the help of a qualified professional. The best resource I have found is being a member of Ed Slott. As a retirement planner, it is critical to stay up to date with the continuing changes in the tax law and how it relates to retirement. If you are interested in working with a Master Elite Advisor associated with Ed Slott, you may go to www.irahelp.com for a listing in your area.
Ed Slott has written several books, one of my favorites is: The Retirement Savings Time Bomb and has a PBS special televised throughout the country: “Stay Rich Forever and Ever” says this about Roth Conversions:
“Roth IRA conversions are the silver lining to the economic crisis. These may be the lowest tax rates you’ll see for the rest of your life.”
If you would like to have a copy of “Key Financial Data for 2011”, which will provide tax rate schedules, Roth contribution income limits, Medicare premiums and deductibles and other key financial data, email [email protected].