Oh what a great year for debate on Roth IRA’s and Roth IRA Conversions! Roth IRAs are a great tool for building up retirement savings, but some things have changed for conversions.
2010 has ushered in some new Roth IRA rules -here’s what you need to know about the 2010 Roth conversions.
I recently received a comment from a reader that I thought garnered a little more attention. Here’s what the reader asked:
My wife and I had traditional non-deductible IRAs and converted at the beginning of this year. We assume that the Roth conversions wouldn’t cause us any tax liability since our contributions to the traditional IRAs exceeded their values at the time of the conversion. Have you heard anything about the tax implications of Roth conversions from traditional non-deductible IRAs?
So what we know from the statement above is that they converted to Roth IRAs from Traditional, non-deductible IRAs. We also know that there were no gains in the account, meaning it was strictly contributions – and they’re wondering what their tax implications will be on this move.
This is a GREAT question!
What is a Traditional Non-Deductible IRA
Let’s define what a traditional, non-deductible IRA is so that we are all on the same page.
Generally speaking a traditional IRA allows money to be contributed pre-tax, which means that you get to take a deduction for it. It’s deductible off of your gross income. This also means that when you withdraw from your IRAs this money becomes taxable at that time!
So, for example, you put in $5,000 to a traditional IRA, you are allowed to subtract $5,000 from your income, which in turn gives you less reportable income to pay taxes on.
Of course the IRS has some funky little rules to spoil how much you can stash into traditional IRAs.
Basically, if you already participate in an employer-sponsored retirement plan – meaning you have a 401k, 403b or SEP IRA etc. – AND you make too much money then you get phased out of your “deductibility” of the IRA and the contributions then turn into non-deductible IRA contributions!
It’s as if you put after-tax money into the IRA.
What are the Income Limitations for Deductible IRAs
Let’s take a look at the rules for tax year 2009:
- If you are a single filer and are covered by an employer-sponsored retirement plan you begin getting phased out of your deductible IRA contributions if you have an adjusted gross income (AGI) between $55,000 and $65,000.
- If you’re married filing jointly, covered under an employer-sponsored retirement plan then you begin getting phased out between $89,000 and $109,000 AGI.
If you’re making more than this then your entire contribution to the Traditional IRA is non-deductible!
What are the Tax Implications of a Non-Deductible IRA to Roth IRA Conversion
Back to the question at hand – how will this affect me on my taxes?
So here’s a couple things to consider:
- What is your basis (contributions to the IRA) and what is the earnings amount? In the reader’s case they didn’t have any gains to worry about. But if they did, they’d have to pay tax on the earnings portion.
- If you had no other IRAs in place (including SEP, SIMPLE and Traditional) then you’re good to go – no taxes due!
- If you did have other IRAs in place, then you may not be in as great a shape as you thought – you may owe Uncle Sam!
Here’s what I mean on the last two:
The rule with a Non-deductible IRA is that you MUST aggregate all your non-Roth IRAs together as one big account when doing a Roth conversion in order to determine the tax liability.
Here’s an example:
Let’s say you have two IRAs with a total value of $30,000. One is a traditional IRA that has a $15,000 balance and all of that is pre-tax.
The other is a non-deductible IRA that includes $15,000 of nondeductible, or after-tax, contributions and no earnings as in the reader’s case.
If you decide to convert all $30,000 of your IRA money, then $15,000 (the amount you contributed to the non-deductible IRA on an after-tax basis) would not be taxable since you’ve already paid the tax on that money.
But the remaining $15,000 would be taxable because Uncle Sam hasn’t got his piece of that pie yet (it’s pre-tax contributions plus earnings that have not been taxed yet)
Let’s say you only want to convert your non-deductible IRA funds since there are no gains and you’ve already paid tax on the contributions – what happens?
In theory, this is a great strategy, but as mentioned, you have to consider all non-Roth IRAs as one big pie.
The Uh-Oh
In the example above, your already-taxed nondeductible contributions of $15,000 account for 50% of your total, while the $15,000 of pre-tax deductible contributions and investment earnings represent the other 50% of your $30,000 IRA pie.
Whether you convert the entire $30,000 or just a slice of it, 50% is considered taxable income.
It doesn’t matter where you take that slice from (non-deductible or pre-tax) – each has the same ingredients of taxable and nontaxable money as the whole!
What You Need to Do
If you find yourself in this situation, you’ll need to fill out IRS form 8606 and wade through the instructions and the mire!
So if I have an IRA that was a rollover from an old 401k the entire amount of it would be taxable right? But given the new rules I would be able to split those tax payments over two years.
Kyle, that’s correct (assuming it was all pre-tax money you put into the 401k). You can pay half your tax in 2011 and half in 2012.
Interesting post on a semi-confusing topic Jason.
What if I only want to convert $7,500 of the $15,000 pre-tax deductible IRA? Does the 50% rule apply there as well, or do I only pay taxes on $7,500? Or do I still pay taxes on $15,000?
@ Darren
If everything you have is “pre-tax” then you should only have to worry about the portion that you decide to convert. Just keep in mind that if you decide to convert the rest at a later time (in the same calendar year) that will also be counted and have to pay tax on. Here’s a post I did on the Roth Conversion Tax Rules: http://www.goodfinancialcents.com/2010-traditional-ira-to-roth-ira-conversion-tax-rules/
Darren – good question, looks like Jeff covered it. If everything inside that IRA is pre-tax then you have to pay taxes on whatever you convert.
If you have any money that is considered non-deductible or after-tax, then that’s when the above rules would kick in.
@Jeff and Jason – Thanks for clearing this up.
@Jeff – nice article by the way.
Hi Jason,
I want to convert my Non Deductible IRA to a Roth IRA. Right now I don’t have any other IRAs. However, I will have a Traditional IRA in July when I complete my 401k rollover. Do I have to consider all IRAs at the time of conversion or in the calendar year? In otherwords, can I convert now and not have to worry about my other IRA because it doesn’t exist yet?
Mike, Great question!! From what I understand (you’ll want to ask a CPA) the conversion is for the year tax year and so is the rollover. They don’t consider individual dates.
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So in your last example, if 50% of the $15k is taxable, doesn’t that mean that 50% of the remaining amount in the traditional IRA is no longer taxable? Otherwise good ol’ Uncle Sam is double-dipping, right?
How does one keep track of this 40 years from now when I start taking distributions?
When I convert, I’ll have the following:
Roth IRA (about $10k)
Traditional Non Deductible IRA ($5k)
401k ($16.5k)
If I don’t convert the 401k into an IRA when I leave this job, will it have to be merged w/ the non deductible IRA for the conversion?
Also, do you think the Roth conversion rules will change any time soon? I was hoping to wait for a really bad year (in terms of being unemployed, etc) and convert then, when my tax bracket was lower. Is that a smart move? Or should I do it now when I can?
Thank you for your article. Are there limits to how much I can contribute to nondeductible IRA? I have no IRAs right now and do not qualify for a deductible IRA. Does it make sense to open a new nondeductible IRA right now, invest as much money as I can, and then convert it to ROTH IRA within a month or so? I am guessing that I am missing something here – this sounds too good to be true.
Thanks!
I have an old IRA with 60000 pretax and 6k nondeductible deposits. I was hoping to open a new nondeductible IRA at a different institution, fund it with 6k in 2010 and 6k in 2011, then immediately convert this new 100% nondeductible IRA to a $12,000 Roth. I figured there would be no gains on that $12000 to tax, and I’d leave the older IRA alone without conversion (paying taxes when I eventually withdraw from it). It sounds from your article like I can’t do that. Am I correct in reading your article that I’d have to aggregate the original $66k IRA and the new $12000 IRA into one $88k IRA before converting any portion to a Roth? Then if I wanted to convert the new $12k investment to a $12k Roth, I’d have to actually take some of the $12k from taxable funds and some from non-taxable? How much would be taxable?
Nathan: I’m in the same situation as you describe, thanks to a 401K that was rolled over into a separate IRA from a traditional IRA that contained only nondeductible contributions. It’s my understanding that yes, Uncle Sam is going to double dip. It could actually be worth converting all of the traditional IRA holdings to Roth (i.e., including the entirety of the rollover IRA) so that the taxable percentage applies to all of the 401K and none of the nondeductible IRA, and the double dip is avoided.
her every cent counts: You do NOT want to rollover that 401K into a traditional IRA if you’re going to do a Roth conversion on that nondeductible IRA–as a 401K, it doesn’t figure into the calculations, but as a rollover IRA, it does.
JA: You don’t need to actually combine the IRAs, you just need to consider them as combined when calculating the amount subject to tax. Jeff Rose’s link above describes it pretty clearly.
Nathan: Correction: I just sat down and went through some examples with a Form 8606–a partial conversion will leave you with some basis in your traditional IRA, while a full conversion will leave you with 0 basis in your traditional IRA (line 14 of Form 8606). So if you do a partial conversion, when you take distributions from your traditional IRA you won’t pay taxes on the nondeductible contributions that still remain in it. In my case, where I have two separate IRAs, one with only nondeductible contributions and one that’s a rollover IRA from a 401K, converting the entirety of what’s in the former IRA and leaving the latter untouched will, in effect, transfer some of the nondeductible basis from the former into the latter.
It would have been much nicer to have not had the rollover IRA to deal with, so that I could have converted the nondeductible IRA to a Roth IRA and only paid taxes on the gains on my contributions, but at least I still won’t be double-taxed on the amount of those nondeductible contributions.
@JA
There is no way to ONLY convert your $12k non-deductible IRA as long as your $60k deductible IRA is open. The IRS will always view what ever amount you choose to convert as 83% taxable and 17% non-taxable, the exactly proportions of all your IRAs.
To do what you want, you have to do something like what I did. I opened a Solo 401k at Fidelity and rolled-over (or reverse rolled-over if you will) all my deductible traditional IRA funds into it. Now the only traditional ira funds I have left are non-deductible and when I convert to a Roth this month (Dec 2010) it will be tax-free.
You could also roll your deductible traditional ira into your current or former employers 401k (if they allow it) to accomplish the same thing.
I will wait until Jan 2011 to do any 401k rollovers from past employers into a new traditional IRA as it’s the balances as of 12/31 that count for everything.
Great article and discussion, thanks.
My wife and I each have non-deductible traditional IRA balanced which we partially converted to a Roth in 2010. My understanding is that we will owe no taxes since the money converted was post-tax, correct?
I have 2 questions:
First, my tax program is indicating that we might have a penalty due to contributions to a Roth for which we were not eligible. Is this a software glitch? I thought there were no income restrictions on a Roth conversion.
Second, how do we keep track of our IRA basis with Roth IRA conversions involved? If we intend to transfer a portion of our nondeductible IRA contributions to the Roth each year, then don’t we need to make sure we are converting a balance that is covered by the original contributions (as opposed to earnings)? Thanks for any help!
What if I have only a non-deductible IRA and cannot contribute to a Roth due to income limits. Is it legitimate to contribute to the non-ded IRA each year and then quickly “convert” to a Roth with basically no tax implications?
Warning to all folks wanting to do this – THAT AGGREGATE rule makes for HELL if you are not careful. I thought I can just define the conversion by account. But since the aggregate rule is used by IRS and I had many 401K rollovers to iras (deductible since 401K is pre-tax by nature), then the sum balance negated the “loss” I had in my non-deductible IRA that I was hoping to convert with no taxes since in that account I had no gain. It was horrible so I had to back-out that conversion and recharacterize the roth ira to a traditional ira real quickly. This AGGREGATE rule was news to me. Yuck,.
Even a year later, these darn rules seem crazy. None the less, Good article. But please clarify something else for me… I had a previous employer’s 401k (IRA) that was role over to my current employer and I contributed to a non-deductible Ira which was immediately converted to a Roth. Am i still suppose to consider my old employer 401k/Ira and my ND Ira as one Ira even though they were rolled over/converted to different retirement vehicles? Could you please clarify how iras get lumped together? Thank you very much.
I plan to contribute $6000 every year to a nondeductible IRA and convert them to Roth. How do I avoid paying tax on the same IRAs each year if I have to aggregate all my IRAs?
Jason,
If I make over all the contribution limits, I can only contribute to a non-deductible traditional IRA. If I do that, can I then (nearly imedeiately) convert it to a roth and only pay taxes on any potential gains I may have had in a couple days? I suppose I could just wait to invest it (keep in cash) until I convert it to a Roth.
Also, I have no other IRAs, only current and old 401ks that are still held at the 401k.
Does this concept work? And if so, isn’t it a work-around for the contribution limits to Roth IRA? It would seem so.
Thanks,
Brad
That’s how I did it. I opened a non-deductible (ND) traditional ira and converted it into a roth the same day. I was pretty nervous that I’d get hit with a tax penalty, but once I did my taxes, I found that I did not owe a penny on the conversion. and yes, i suppose this does appear to be a work-around for the contribution limits for roths.
When I use Turbotax, the conversion ends up showing as taxible distribution. Any work around other than manually fill out the return?
Thanks,
Wei
With the example of deductable and non-deductable monies – move the deductable monies (IRA and gowth on the non-deductable contributions) into your 401k or retirement plan, if allowed by your plan, thereby leaving the deductable contributions sitting by itself in the IRA. Then do the converstion of the remaining IRA to a Roth with no tax consequence. Later, when you close the retirement plan, by rolling over into a new IRA, there will only be monies the government has to tax and no ratio to deal with. Plus you will have moved more of your money into a Roth giving you the flexibilty to take it when you want.