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Roth Conversion Tips and Traps

Christine Benz

Christine Benz: Ed, we've seen a lot of folks doing conversions over the past year. Wondering if you can talk about some of the key traps or mistakes you've seen or heard about people making with their IRA – Roth IRA conversions?

Ed Slott: Yeah. Once you convert, one of the biggest mistakes people make is not filling out a new beneficiary form. Once you've converted, say, your IRA or 401(k) funds to a Roth you now have a new account, it needs a new beneficiary form, and most people, including advisors, don't realize this. It doesn't carry over from the other vehicle, let's say, from the IRA, so that's one thing.

I mean that's a core. The beneficiary form is a single most important document. It trumps the will, it will determine the ultimate future value with that Roth IRA, and it determines which tax benefits your children and grandchildren will get. It will also determine if the right beneficiaries are getting the money. So that's the first thing. When you open a new Roth, that's a new account, it needs a new beneficiary form.

There are some other traps--and I don't know if I'd call them traps, but things to be aware of, when you convert to a Roth IRA. The years you include the income--because you have to pay tax on the value, you have to pay tax to convert--your income will be higher those years. So, if you normally make, say, $50,000 a year or $100,000 a year, and one year you have a $300,000 conversion, what you're going to have, a spike in income for that one year. What that could do--many items on the tax return, like the good items, the things you can deduct, like your deductions, exemptions, credits, a lot of them are tied to your income--you lose some tax benefits, and that you should be aware of when you have a spike in income. Not that it's bad, but so you don't get hit with surprises.

There are some things you should be aware of. I can name a few, but I'll name one now, off the tax return items. Here's a very common case that we've come across. Let's say you have a child going for financial aid. All of a sudden your income spikes by $300,000 or $400,000, that's not the year you want to convert, if you're showing that tax return to people at financial-aid at a college. You have flexibility with a Roth conversion, so don't convert that year you're trying to apply for financial aid.

So, those are some of the negative aspects, but they can all be dealt with.

Benz: Ed, you had also mentioned to me that that people who have done the conversion are going to have to file this Form 8606 with their tax return. Can you talk a little bit about that? What's on it, and what people should know about it?

Slott: Yeah. Everybody has their 15 minutes of fame, somebody once said,  I think Andy Warhol said that. And 8606 is a tax form, doesn't have a lot of sizzle to it, but it's called Nondeductible IRAs, and some people used it in the past, it wasn't that popular. But all of a sudden it's the popular kid in school because this is the form where Roth conversions have always been reported. Not everybody could always do Roth conversions. Two new things happened in 2010, and people are filing their 2010 tax returns now in 2011. Once they approach this, they're going to realize they're going to have to deal with this form that they may never have had to deal with; CPAs too who are doing tax returns.

So the two new things that happened in 2010, number one, all the income limits for conversions, like I said before, were removed, which means everybody with an IRA or 401(k) or 403(b) qualified for a Roth conversion. So there is a much bigger pool of people. All the fund companies, as you know, were reporting an uptick in the number of conversions, so many more people will be filing this form than ever before. The other thing is, in 2010--and this was only for 2010--if you converted in 2010, you could spread the income over 2011 and '12 and not report anything in 2010. That's a great deal considering that the new law extended the tax cuts for '11 and '12.

So, all of that has to be reported on Form 8606. You actually have to make an election. You get the two-year deal if you convert it in 2010, and most people should take that. Being that rates are the same, why wouldn't you just pay later? Well, there is a situation where you might want to elect out of that and you do that on Page 2 of Form 8606, and report all the income front-loaded at 2010.

Why on earth would you do that? Only in the situation where 2010 income was really low. Maybe you had a bad year, you have a very low bracket. If you can get it at a much lower bracket, then it would cost you in '11 and '12, it might pay to put it in, in 2010. Maybe you had a business, and you took advantage of some other provision to the new tax law, like accelerated depreciation, and it created huge business losses. The conversion would cost you very little, you might want to put it in, in 2010.

So you have those issues, you can elect that on that form, but a lot more people will be dealing with this form and there are a bunch of questions to ask here. If you have this situation, I would look at the instructions or maybe get professional help. If you did your returns by yourself all these years, I would get professional help to make sure that form is submitted properly. If you have a joint return, each spouse has to submit their own form. If you have different types of conversions, say from a plan to a Roth, or a plan to a Roth 401(k), or an IRA to a Roth. Even individual taxpayers might have to file two of those forms. You can have a situation where you could file four of these forms with one tax return.

So, it's a little crazy this year with this form that all of a sudden is the popular form on a lot of people's tax returns that they never had to deal with before.