My Traditional to Roth IRA Conversion Decision Process

For the best site that I’ve found to the Traditional-to-Roth IRA conversion process (and more clear than the IRS instructions), see the Fairmark guide. Reading through it, you can see there are a ton of variables to consider, including evaluating your current situation and predicting future legislation. Here’s a summary of my decision process after reading the guide:

Am I Allowed To Convert?
My main concern was the income limits. No matter if you are single or married, your total combined modified adjusted gross income (MAGI) cannot be over $100,000. The definition of MAGI is pretty confusing – either read Pub 590 or better yet Fairmark again for the details. But one way to lower your MAGI is to make contributions to your employer’s retirement plan (401k, 403b). Making more pre-tax contributions to enable you to convert pre-tax contributions to post-tax contributions may seem a bit paradoxical, but I just see it all as increasing your retirement savings.

Note that the income limits are scheduled to be removed in 2010.

What Types Of IRAs Can I Convert?
You can convert both a SEP-IRA or Traditional IRA into a Roth IRA. You can also convert an old 401k/403b/457 plan from your employer to a Traditional IRA, and then convert that to a Roth IRA if you satisfy all of the conditions. My current Traditional IRA is a mishmash of all three of these – an old Rollover 401k, straight Traditional IRA contributions, and a SEP-IRA.

Should I Convert?
A big part of this question relates to whether you like the idea of being taxed now and not later (Roth), or taxed later but not now (Traditional). This involves comparing your current marginal tax rate and your estimated tax rate in retirement. For some of us this involves looking 30+ years in the future. Who knows what the tax brackets will be then. Most people tend to guess higher. But it’s also a possibility that Roth IRA distributions may also be taxed for those having certain income levels. Who knows.

You can also “fit more money” into a converted Roth IRA. For example, by turning $1,000 of pre-tax money into $1,000 of already-taxed money, you pay more out-of-pocket now but will save yourself that huge tax bite in the end. Just be sure you have the money to cover the conversion.

My opinion is that our current tax bracket of 25% is historically not that high, and it is more likely to be higher during retirement than lower. On the other hand, we also would like to have some more cash on hand for a house down payment.

How Much Should I Try To Convert?
You can actually do a partial conversion if you like. One reason to do so is that the amount of the rollover will be considered income and it may push you into the next marginal tax bracket. You may also lose some tax credits that are sensitive to income. That wasn’t an issue for me, so I went ahead and converted over the entire amount.

How To Pay For The Conversion
As previously mentioned, you should really be able to cover the tax from the conversion using existing funds from outside the IRA.

State Income Taxes
You may want to consider specific state tax consequences as well.

After some swaying back and forth, I went ahead and sent in the paperwork by the year-end deadline to Vanguard in order to start the conversion. This means owing an extra several thousand dollars in taxes this year. I also considered waiting until 2010, but by then I would likely be in a higher tax bracket than now. I am still able to reverse the conversion until as late as October 2007 without paying taxes or penalties if I change my mind.

Comments

  1. Hey, quick question:

    I’m thinking about starting a Roth IRA through Vanguard. I know that I can contribute through April 15th and still fall within the 2006 limits (and be able to contribute the full amount for 2007, as well), but did I have to open the account before Dec. 31, 2006? Basically, if I open a Roth IRA now and contribute before April 15th, will it be considered within 2006 contribution limits, or 2007?

  2. The conversion process can be tricky. I have never do it myself, but will look further into this. Thanks.

  3. Yeah, I converted $11,000. I also funded $15,000 to my 401(k) so these kind of cancelled each other out. I agree the 25% rate limit is artificially low. Bush postponed taxes. Lucky future! Interesting point about potential changes to the Roth laws! I still have about $5k to roll… hopefully 2007 will cover all the standard deductions 100% like 2006 did… but for now I have to earn to pay off the tax debt. Never going 25% again, if I can help it, by maximizing deductions, minimizing costs, maximizing investments. The usual!

  4. Hunter – No, you didn’t have to open the account before 12/31. You do have to state clearly for which year you are making the contributions for though, and double-check with your IRA administrator that they recorded it correctly.

  5. Thanks for this. I am planning a 403B –> Conversion IRA –> Roth IRA. Do you know if there are limits to how much you can convert in any 1 year? If not, doesn’t this allow someone to get around ROTH limits?

  6. I don’t think there are any limits, but it may be partially taxed at the next higher tax bracket. You can only convert after you leave the job as well, so it’s not a workaround that can be repeatedly easily.

  7. Looking forward to that 2010 date! Haven’t made the final decision yet, but I will be strongly looking at converting.

  8. Dan Weber says:

    My suggestion, for those considering converting a traditional IRA to a Roth IRA is to perform the conversion at the BEGINNGING of the year, such as the first week of January. You will have to pay taxes on the fair market value (FMV) of the amount converted. This is the value as of the date it was actually converted.

    Then, near the END of the year (end of Nov), take a look at the value of what you converted in the first of the year. IF the value of your conversion has went down, then UNDO the conversion (called Recharactizing a Roth Conversion) since you will have to pay taxes on the value at the time of the conversion.

    If, however, the value near the end of the year is higher, then keep the conversions since you only have to pay taxes on the value at the time of conversion, which is a lower amount.

    For example, say your account at XYZ mutal fund is worth $20,000 in Jan. Convert it to a Roth. If the $20,000 goes down to say $15,000, then undo the conversion — why pay taxes on $20,000 for something that’s now worth $15,000.

    If the $20,000 has grown to say $25,000, then stay with the conversion and realize you only have to pay taxes on $20,000 for an account that’s worth $25,000.

    You can repeat this every calendar year, as long as you wait at least 30 days between each Roth conversion (which is why I suggest making the decision in late November).

    What do you think of this strategy?

  9. Rob > If not, doesn?t this allow someone to get around ROTH limits?

    Yes you can get around Roth contribution limits & phase our limits every year that you make less than $100K MAGI.

    For example, in 2005 I made too much to fully fund my Roth (phase out) but I’d be making less than $100K MAGI (salary – 401k) in 2006, so before April 15th in 2006 I put the excess contribution (4000 – what I was able to contribute directly to my Roth) into a Non-Dedcutable IRA then did an immediate Roth Conversion (no taxes since there was no gain). Full Roth Contribution even though I was in the phase-out range… An imoportant note – when you do a Roth Conversion the IRS sees all of your traditional IRAs as a pool, so if you have a tradiotional IRA from a 401(k) rollover then the above trick doesn’t work since you will owe taxes on a portion of the money…

    Also you can use the above strategy if you make too much money to contribute to a Roth but you plan to take a year off down the road (or if the 2010 loophole doesn’t get closed) You simply make non-deductible IRA contributions each year then when you take your year off (meaning you make less than 100k), you do the conversion.

  10. Steve Austin says:

    couple of questions/comments on the above comments:

    1. Dan Weber proposes a tax optimization strategy of some sort — if I followed the gist, the strategy is to base a conversion decision upon the short-term (i.e. annually evaluated) vagaries of one’s IRA account balance? on the surface, I believe I follow the logic, but look under the covers and one sees that making a tax decision upon an account balance at some given time each year doesn’t seem consistent — e.g. as in the example where a $20k account has grown to a $25k account and the account holder decides to maintain the conversion (i.e. not re-characterize), but 6 months later the account has dropped to $15k — in other words, in November one says, “okay I have $25k, so I’ll just pay taxes on the $20k that I had at the time of conversion”; then in May one says, “well now I only have $15k, but I already paid taxes on $20k several months ago!” — seems to be a case of inappropriately considering short-term account balances when making tax decisions that have an effect long past that time frame — please let me know if I (mis)understand the strategy proposed

    2. I see a reference to the term “Non-Deductible IRA” — is there such an animal? I am aware of a standard/traditional IRA, to which one may make both deductible and non-deductible contributions, and one accounts for those two parts on one’s own books (IRS and financial service providers don’t do this for one, do they?) I realized that the non-deductible conversion taxed-only-on-gain doesn’t apply to a 401(k) rollover (entirely a deductible contribution traditional IRA, true?) so I’m still ruminating on how/when to best effect a series of annual partial Roth IRA conversions for my 401(k) rollover IRA.

  11. One question I’m hoping you may be able to answer that I have not seen is whether you can do a conversion of a traditional IRA into an EXISTING Roth IRA in 2010. I currently have a Roth IRA but this year (2007) will be the first year I will not be able to contribute. If I start a traditional IRA and fully fund it every year (with non-deductible contributions) from now ’til 2010 (i.e. 2007, 2008, and 2009), can I convert this new, traditional IRA to my current Roth IRA (to which I’ll have made no contribution 2007-2009)?

  12. I just found this site and am thrilled that I did as these are exactly the types of topics I am interested in learning more about.

    I currently have three separate Roth IRA accounts:
    1) conversion of an IRA when the Roth first became available (tax paid over 4 years)
    2) conversion of a prior 401k to a IRA to a Roth IRA (tax paid in following year)
    3) direct contributions to a Roth IRA (after-tax contributions)

    Since these all have had had their taxes previously paid, is there any reason to continue keeping them segregated? Or can I transfer all my holdings into one account? After reading about the Well Fargo 100 free trades deal, I am thinking of moving my accounts over and would prefer to keep it simple and move them all to one account if there is no reason for me to keep them separated.

  13. Response to Mase:

    Yes you will be able to convert your traditional IRA to a Roth in 2010. Whether it needs to be a “new” Roth IRA or directly into your existing account kind of comes back to my question above about whether different contribution types need to be kept separated. The only thing I can think of for conversions is that you might want to keep it separated at least until the end of the tax year. This allows you to make the decision discussed above on whether you want convert back to a traditional IRA (if the value of your account has decreased) before the end of the year. Once you’ve left that coversion to a Roth in place, then you can consolidate it into your existing account simply for ease in maintenance (having one account instead of two).

    Looking forward to 2010, it seems to me that with a little creativity, there might be a loophole in doing that conversion though I don’t know what it is. Is there some type of investment that would have a low value at the time of conversion in 2010 (so that you pay less tax) and then matures/jumps up/dramatically increases shortly thereafter? Maybe there is some type of investment (think beyond stocks and bonds) for something that could momentarily have an artificially low value. Remember that IRA accounts have a very broad scope of eligible investment types.

    Is the conversion value as of 12/31 or on a date on which you chose to make the election?

  14. Barry – If you keep them separated, you may still be able to reverse the conversions, depending on how long ago you did it. After they are commingled together, I believe that option goes away.

  15. Hi everyone, sorry I am new to this site, but I am trying to learn answers to a few questions I have. Seems I am in a similar situation to Mase.

    I have contributed to my ROTH for 3 years now (at $4000 per year), but as of this year (end 06) I cannot contribute to a ROTH (due to limits on salary, etc).

    What are my best options? Should I be contributing my new $4000 to a Traditional IRA? Mutual Fund instead? If I chose a Traditional IRA, what should I be looking for (good and bad)?

    Any help and advice would be most appreciated. I know I must do something soon and just looking for guideance.

    Thank you,
    Josh

  16. Christopher L. Baldwin says:

    Hi All

    I am totally new to this website. I am 55 with a $1.8 mil Traditional IRA. While my situation is somewhat complex, suffice it to say that I am serioulsy considering converting $1 mil of my IRA to a Roth this year before the tax rates start creeping upward to pay for the gap in Social Security and Medicare … and to catch people who want to convert in 2010. My income is under $100,000.

    Question: A friend told me that in 2010, there will be NO STATE tax on any IRA conversion regardless of the domicile state. Is this true? I never heard about this.

    Question: If I convert $1 mil, does the $1 mil count as adjusted gross income in computing the $100,000 income test. I heard that once upon a time it did count, but the IRS realized its mistake and corrected it. What is the truth? Could you direct me to a pub;ication or website that would give me additional comfort?

    I have created a fairly sophisticated and comprehensive model in excel that compares the Traditional IRA with a Roth IRA conversion and assumed additional debt. For anyone who helps me with my questions, I am willing to share that model with you. However, you need to convey to me your email address in your response. The thought police at MyMoneyBlog might not permit email addresses to be sent, so send it in code like ………….. JohnDoe at Carolina dot rr dot com.

    Thank you very much,
    Chris B

  17. I am considering Converting MY Traditional IRA into a Roth IRA. However I contributed I think $6,000 to my Traditional IRA and is now Worth about $60,000. Would I have to pay taxes on the Conversation on the The FMV or on the amount I originally contributed?

    And what is this Rule in 2010 about?

    Thanks

    Jeff

  18. You would have to pay taxes on the full converted amount, $60,000. In 2010, the income limits are scheduled to be removed (see post).

  19. Chris, Baldwin. Would love to see your spreadshheet. Send to gpk111 at hotmail. Thanks

  20. If i have an MAGI for the year of less than 20k before conversion and convert 200k of my IRA to a Roth, does the conversion get added into my MAGI to compute my tax rate. one way it would be 15% the other way it is 30+%. My understanding was conversion tax rate was based on the my AGI prior to the conversion.

  21. Early in 2007 both my husband and I made a full ROTH IRA contribution, as we have since the ROTH IRA was available.

    We did not believe we were going to make more than 100K this year and did not even think about it. Our taxable income had been about 85K before 2007. What do I have to do if my husband and I already made a 2007 contribution to our ROTH IRA and we found that we went over 100K for the 2007 tax year?

  22. Hello All!

    I recently converted my traditional IRA to a Roth IRA in Dec 2008. Prior to the conversion, in Nov 2008, I had made a contribution to my traditional IRA. I currently received a 1099 of the amount at hand during my conversion in Dec 2008 which includes my 2008 contribution. I was wondering if I have to pay taxes on the full amount listed in the 1099? I was hoping to deduct my 2008 contribution since I have yet to have claimed that on my 2008 taxes. If I do have to pay taxes on the full amount, can I also claim the 2008 contribution to the traditional? Thanks in advance!!!

  23. Douglas Wilson says:

    There is nothing to consider before converting to a Roth IRA. I thought there were certain things to assess before converting just like everyone else; but after I read The Gospel of Roth by John Bledsoe, it was clear that I should convert. The book completely contradicts what I had been reading off every news site and explains how converting as soon as you can is the best option. Because you don’t have to decide whether you want to keep it as a Roth IRA or convert it back to a regular IRA until October 17th, 2011, converting now is like having a free look at the future. If it proves better to convert, then you already converted. If you should have left it as an IRA to save taxes, then convert it back free of penalty. The Gospel of Roth is easy to read and straight forward, and practically made my decision for me.

Trackbacks

  1. [...] In my post about Roth IRA conversions, commenter JT pointed out a good way to get around the Roth IRA income limits if your income varies from year to year. Simply put contribute to a non-deductible Traditional IRA, and wait until your modified AGI drops below the $100,000 limit to do the conversion into a Roth. Maybe you plan on going back to school or are cutting back your hours to stay home with the kids? Although the limits go away in 2010 anyways, it’s something to consider. For example, in 2005 I made too much to fully fund my Roth (phase out) but I?d be making less than $100K MAGI (salary – 401k) in 2006, so before April 15th in 2006 I put the excess contribution (4000 – what I was able to contribute directly to my Roth) into a Non-Deductible IRA then did an immediate Roth Conversion (no taxes since there was no gain). Full Roth Contribution even though I was in the phase-out range? [...]

  2. [...] to again meet the income limits, and make sure your new tax bracket is acceptable to you. I did a Traditional to Roth IRA conversion in 2007 and shared my decision process, including the eligibility requirements and how to pay for [...]

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