conversion of after tax IRA to roth
Client rolled out of qualified plan his after tax 401k into an IRA. Can this account be converted to a ROTH? His income this year will be less than 100k..
Client rolled out of qualified plan his after tax 401k into an IRA. Can this account be converted to a ROTH? His income this year will be less than 100k..
Permalink Submitted by Alan Spross on Thu, 2009-07-23 19:40
As long as his modified AGI is not over 100,000 this year (and he does not file married separate returns), he can convert all or part of his TIRA to a Roth IRA. Since he has rolled over after tax money to the IRA, he must report that on an 8606. The conversion will be partly tax free using the pro rate rules for all his traditional, SEP and SIMPLE IRA accounts. He cannot figure the factor using just the account that he converts from.
If he waits until next year to convert when all the limitations for conversion disappear, he can also defer the tax bill to 2011 and 2012 by reporting half the conversion income in each of those years. At this point, it might be worth waiting to do that, but if there is an advantage to using his 2009 and 2010 brackets, then he might opt to convert some incremental amount each year. The idea is to not convert so much in a single year that the marginal tax bracket is increased.
Back to your main question, if he put this after tax amount into a separate account, converting that particular account will not be tax free unless he has NO OTHER traditional, SEP or SIMPLE IRA accounts.
Permalink Submitted by Geoffrey Kasher on Thu, 2009-07-23 19:46
Please clarify your last sentence..
He does have another pre-tax IRA that was the roll out from the same plan..
He anticipates his earned income over the next years to be less than 100K.
Thanks for the help.
Permalink Submitted by Alan Spross on Thu, 2009-07-23 20:52
Because he has a pre tax rollover from the same plan, the pro rate rules will apply to any conversions regardless of which accounts are converted. For example, if his after tax rollover was 10,000 and his pre tax rollover was 190,000, then his IRA total is 200,000. Any conversion will be 95% taxable and 5% tax free based on this example, whether the conversion comes out of the pre tax IRA or after tax IRA. The number of actual IRA accounts is immaterial.
With respect to the tax bracket that applies to conversions, his taxable income determines that, not just his earned income. Any conversions add to taxable income so if too much was converted in a single year, the tax bracket could increase, eg from 15% to 25%, plus any state income tax increases. If taxpayer expects to be in the 15% bracket in retirement, it would not make sense to convert in the 25% bracket. If the retirement tax rate is expected to be about the same, then converting smaller amounts can be beneficial in providing “tax diversification” in retirement. The Roth portion will not be subject to RMDs, but can be used for distributions to stay out of higher brackets in particular years. TIRA RMDs will be reduced as a result of Roth conversions, and additional distributions can be taken if high deductible medical or other expenses will keep the taxes down in certain years. This is a major benefit of having a mix of both pre tax and Roth retirement assets.
Permalink Submitted by Bruce Steiner on Thu, 2009-07-23 21:58
At a constant tax rate, conversion is generally beneficial. For example, suppose you have a $100 traditional IRA and $30 of other assets, and you convert. You now have a $100 Roth IRA. Over some period of time, it grows to $200. If you didn’t convert, your $100 traditional IRA would also grow to $200, or $140 after taxes. But since you would have some investment income and gains on your taxable account, it would grow to something less than $60. The Roth also avoids required distributions after age 70 1/2 (which can be significant), and provides other benefits.
If you’re going to be in a lower bracket in the future (such as upon retirement), you have to consider whether to convert now (in a higher bracket) or to wait until retirement (when you’re in a lower bracket).
For many people, there’s a tradeoff between converting all at once (which gets more assets into the tax-free Roth environment sooner but bunches the income, which can put you into a higher bracket) or spreading the conversion out over a number of years.
Another factor is your beneficaries’ tax brackets if you don’t convert.
A good rule of thumb is that the conversion is beneficial to the extent it puts you in only a little bit higher bracket, but not to the extent it puts you into too much higher a bracket.
Those who and whose beneficiaries will always be in the top bracket generally convert all at once, as do those in low brackets with very small IRA. Those in between often spread the conversion out over a number of years, beginning when they’re in a modest bracket (generally at retirement). Of course, until the end of this year, only those with income under $100,000 could convert.
There are some other factors that can affect tax rates, such as the alternative minimum tax, taxation of social security benefits, various phaseouts, state income taxes. I suggest running some numbers, or having an accountant run some numbers.
I think the concept of tax diversification is overrated, except to the extent that spreading the conversion out so that it doesn’t push you into too high a bracket is proxy for it.
Since the $100,000 income cap is scheduled to expire at the end of this year, I and others will be speaking and writing about this more later this year and next year.
The above is intended as general information only. IRA owners should consult with their own advisors, who can give them specific advice based upon the facts of their situations and their objectives.