The Ins and Outs of IRA Conversions

IRA-conversion mania is in full swing. That's because in 2010, savers of all income levels can convert their IRAs from a traditional to a Roth. Many financial-services companies are clearly using conversions as an opportunity to get their mitts on your assets--that is, stop in to see if a conversion makes sense, and while you're here we'll sell you some of our wares. Your portfolio may well benefit from the help, but in this instance I'd rather see you get the conversion advice from a completely neutral party, such as an accountant, rather than from someone who stands to benefit from your decision to convert.

I've written articles on conversion, but I've also been receiving some more-specialized questions, which I'll tackle today.

Q: I've heard there is a five-year waiting period to begin withdrawing assets once I've converted my IRA. I'm a 77-year-old retiree who's taking distributions from my IRA for living expenses. Does that rule apply to me, too?

A: No. It's true that those who are under age 59 1/2 must wait five years after making a conversion to begin withdrawing assets from their Roth IRAs. If you don't observe that five-year waiting period and you're under 59 1/2, you'll owe a 10% penalty on the premature withdrawal. If you're over age 59 1/2, that rule doesn't apply. You can take withdrawals at any time without incurring a penalty.

If you are younger than 59 1/2, the five-year waiting period begins on the first day of the tax year in which you made the conversion. For example, say you converted your IRA to Roth status in December 2009. If you're under 59 1/2, your five-year waiting period for those assets began on Jan. 1, 2009. If you convert additional assets later on, they'll be subject to a separate five-year waiting period.

Q: I've taken a look at the taxes I'll pay to convert my traditional IRA assets to a 401(k), and it's not pretty. Can I do a partial conversion?

A: Yes. Partial conversions are permissible and can be a great strategy, particularly if you've done the math and determined that converting all of your IRA assets will push you into a higher tax bracket for the tax year in which you convert. Partial conversions can also make sense if you don't have the cash on hand to pay the taxes associated with a full conversion. (Whatever you do, don't tap your IRA assets to help pay the taxes: You'll pay a 10% early-withdrawal penalty on any assets you don't roll into the Roth.)

Bear in mind, however, that you can't pick and choose which IRA assets to convert--for example, you can't convert all of your nondeductible IRAs and leave your deductible IRAs intact, although that would result in a lower tax hit because you've already paid taxes on those nondeductible contributions. Instead, the IRS considers all of your IRAs as one big pool when calculating your tax burden. Each dollar you convert will receive exactly the same tax treatment based on your aggregate IRA's breakdown between deductible contributions/investment earnings (taxable) and nondeductible contributions (not taxable).

For example, say you have $100,000 in an IRA that's composed of $30,000 in deductible contributions, $10,000 in investment earnings, and $60,000 in nondeductible contributions. In that case, 40% of every amount that you convert would be taxable upon conversion (that 40% encompasses deductible contributions and investment earnings), whereas you wouldn't owe taxes on 60% of your conversion (the percentage of your IRA portfolio represented by nondeductible contributions). Each subsequent conversion that you do would receive the same 40% taxable/60% nontaxable treatment.

Q: My wife and I don't have any IRA assets because we earn too much to qualify for a Roth IRA. Does this mean I can open a traditional IRA now and then convert to a Roth next year?

A: Yes. Income limits on new IRA contributions still remain in place; in 2010, single filers earning more than $120,000 and those who are part of a married couple filing jointly that earns more than $177,000 cannot make Roth IRA contributions. However, it's possible for those high-income earners to take a backdoor way into additional Roth contributions by making nondeductible IRA contributions and then converting shortly thereafter. It's possible that Congress may close this loophole down the line, given that it doesn't make sense to leave the income limits in place for initial contributions but not conversions. But for now it looks like an opportunity.

Q: What if the government rescinds Roth tax treatment? Is there a possibility my assets will be taxed upon withdrawal?

A: There has been a lot of debate about this question, and, unfortunately, there are few clear answers. Almost anything is possible when it comes to the tax code, and I agree that the long-term trend in tax rates is likely to be upward. But you can take comfort in a few points. First, the Roth IRA has heretofore been a tax-sheltered vehicle targeted toward middle-income savers--contribution limits have kept out the highest-income earners. Raising taxes on middle-income earners is apt to come with significant negative political repercussions.

And in a worst-case scenario, if the tax treatment for Roth IRAs is rescinded, it would very likely only affect earnings growth on the investments, as Roth IRA contributions have already been taxed. That would be a bitter pill to swallow, of course, but not nearly as bad as paying taxes on the whole amount.

Q: I have assets sitting in my former employer's 401(k) plan. Can I earn Roth treatment?

A: Thanks to the Pension Protection Act of 2006, shifting those assets into a Roth is much like doing a conversion from a traditional IRA to a Roth. You'll owe taxes on all of the pretax assets in the plan at the time you make the conversion (Roth 401(k) assets aren't taxable). Beginning in 2010, individuals at all income levels will be able to roll over from a company retirement plan directly into a Roth; prior to 2010, investors needed to have incomes of less than $100,000 to do a direct rollover into a Roth IRA.

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