Ever since the advent of the Roth IRA in 1997, taxpayers have struggled with the dilemma of how to convert their traditional IRAs to Roth IRAs without going over the income limit. Those earning healthy incomes that have accumulated six-figure traditional IRA balances have only been able to convert a small portion of their IRAs over each year, due to the $100,000 aggregate income limitation on Roth conversions. Fortunately, this restriction is going to be lifted starting in 2010. This article explores the new rules for Roth conversions that were introduced in the Pension Protection Act of 2006. (For in depth background information, refer to Roth Or Traditional IRA ... Which Is The Better Choice?)

The Conversion Dilemma
It has taken years for many taxpayers to be able to convert their traditional IRA balances over into Roth IRA accounts. For example, a taxpayer earning $75,000 from his or her corporate job with no other sources of income could only convert $25,000 of his or her traditional IRA into a Roth each year because of the conversion income limit rule. This means that if he or she had a traditional IRA balance of $200,000, it would take eight years to convert the entire account to a Roth - and even longer if any other income is realized during that time. Additionally, other restrictions, such as an income exceeding $120,000, prevented individuals from transferring funds to a Roth IRA. Obviously, this restriction greatly handicapped the conversion process for upper-income taxpayers and those with large IRA balances. Congress therefore decided to address this issue in the Pension Protection Act of 2006, which revised the conversion and contribution rules for Roth IRAs starting in 2010.

The Pension Protection Act Provision
The Pension Protection Act effectively lifted the income limitation on Roth conversions that had previously applied. As of January 1, 2010, taxpayers with modified adjusted gross incomes of more than $100,000 could convert their entire traditional IRA into a Roth in a single year, regardless of the amount of the IRA or the tax consequences. This means that the taxpayer in the previous example could effectively move all $200,000 into a Roth IRA in one year, instead of having to do so over many years.

Tax Consequences
Of course, just because it is now possible to convert a large IRA into a Roth IRA in one year doesn't necessarily mean that that is automatically the best course of action. Converting a large IRA can easily land a taxpayer in a higher tax bracket, which could result in unnecessary taxes that could be easily avoided by spreading the conversion out over two or more years. For example, a couple with current annual income of $150,000 should think carefully before converting a $200,000 IRA in a single year, because this would most likely result in an avoidable increase in tax liabilities. If they were to convert half of their IRA this year and half next year, this gradual process would lead to some tax savings compared to the initial alternative. Some tax planning may be required in order for taxpayers to determine how much they should convert in a given year. Furthermore, the legislation stipulates that taxpayers can spread the payment of tax on any Roth conversion performed in 2010 over two years. This means that taxpayers who convert their IRAs to Roth IRAs in 2010 can pay part of the tax in 2011, and the rest in 2012.

Another tax factor to consider is whether there are any credits available to cancel out the additional income from the conversion. This issue generally applies to low and middle-income taxpayers in the lower brackets. Many times, taxpayers may end up with either no taxable income or no actual tax bill, because their taxable incomes are either too low or they are eligible for credits that cancel out their tax, such as the earned income credit or credits for higher education expenses. If this is the case, then a larger conversion amount may be permissible, because the additional income may simply be absorbed by unused deductions or credits. (To find out how you can pay less tax, read Cut Your Tax Bill.)

Example
Last year, Morgan had income of $100,000, but no tax bill and unused tax credits worth $1,500, due to the college tuition and fees that he paid for his daughter. This year, he expects his tax situation to remain the same, except that he will convert his $30,000 IRA to a Roth. The unused tax credits will therefore cover most or all of his additional tax balance due to the extra income arising from the initial withdrawal. If his unused credits in 2010 are not sufficient to pay the entire amount, then he should consider converting the excess portion the following year, so as to avoid paying unnecessary tax.

This strategy can be especially effective for those who have been laid off. A taxpayer who was earning a steady salary of $75,000 but got laid off has probably arranged his tax deductions and credits to accommodate this income. If the taxpayer finds temporary work paying $25,000, then a Roth conversion for the difference in income (or close to it) could recapture some or all of them. The declarable income from the Roth can serve nicely to replace the earned income lost from the layoff when it comes to tax planning. (For more information on the proper conversion process, read Did Your Roth IRA Conversion Pass or Fail?)

Conclusion
The removal of the income limitation on Roth conversions has made financial and retirement planning easier for many Americans. However, there may still be times when taxpayers can save money by spreading their conversions out over two years or more. For more information on Roth conversions and which course of action is best for you, consult your tax or financial advisor. (For related readings, see The Simple Tax Math Of Roth Conversions.)

Related Articles
  1. Investing Basics

    Understanding How Dividends Are Taxed

    Learn how dividends are taxed by the IRS, and understand the different types of dividend income as well as the capital gains tax rates.
  2. Investing Basics

    6 Reasons Why Dividends Should Be Reinvested

    Learn about the advantages of dividend reinvestment programs and how they may benefit longer-term investors who want to build a position in a company.
  3. Retirement

    Retirement Planning for Entrepreneurs and Small Businesses

    If your business has receiveables, here's a smart way to leverage them to build up your retirement fund fast.
  4. Retirement

    Overhaul Social Security to Fix Retirement Shortfall

    There are several theories and ideas about how we can make up for the $6.6 trillion retirement savings shortfall in America. Adjustments to Social Security and our retirement savings plans are ...
  5. Taxes

    What IRS Form 990 Tells About a Nonprofit

    Want a picture of an organization's activities? This annual form, open to the public, sums up everything from salaries paid to missions accomplished.
  6. Retirement

    The 3 Most Common 401k Rollover Mistakes

    No one is born knowing the tax rules for 401(k)s and IRAs, but only dummies, scaredy cats and suckers don't buckle down to learn them.
  7. Taxes

    Top Reasons to File Separately When Married

    Most of the time, it makes sense for couples to file their taxes jointly. Except for these possible exceptions...
  8. Taxes

    What IRS Form 1023 Is Used For

    To be treated as a tax-exempt organization, start by filling out this form.
  9. Taxes

    Late with Your Taxes? Grab IRS Form 4868

    Fill out this form to get a few more months to file your tax return. But remember, April 15 is still the payment due date if you owe taxes.
  10. Investing News

    How Does US Social Security Measure Up Abroad?

    Social Security is a hotly debated topic. After examining the retirement plans of three different countries, the U.S.'s does not come out the winner.
RELATED TERMS
  1. Receivables Turnover Ratio

    An accounting measure used to quantify a firm's effectiveness ...
  2. International Financial Reporting ...

    A set of international accounting standards stating how particular ...
  3. Days Sales Outstanding - DSO

    A measure of the average number of days that a company takes ...
  4. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis ...
  5. Surplus

    The amount of an asset or resource that exceeds the portion that ...
  6. Cash Flow

    The net amount of cash and cash-equivalents moving into and out ...
RELATED FAQS
  1. Can my IRA be garnished for child support?

    Though some states protect IRA savings from garnishment of any kind, most states lift this exemption in cases where the account ... Read Full Answer >>
  2. Can I use my IRA savings to start my own savings?

    While there is no legal reason why you cannot withdraw funds from your IRA to start a traditional savings account, it is ... Read Full Answer >>
  3. Can creditors garnish my IRA?

    Depending on the state where you live, your IRA may be garnished by a number of creditors. Unlike 401(k) plans or other qualified ... Read Full Answer >>
  4. How does an IRA grow over time?

    Individual retirement account, or IRA, growth depends on many factors, including what types of investments are included in ... Read Full Answer >>
  5. Can you buy penny stocks in an IRA?

    It is possible to trade penny stocks through an individual retirement accounts, or IRA. However, penny stocks are generally ... Read Full Answer >>
  6. Can I use my IRA to pay for my college loans?

    If you are older than 59.5 and have been contributing to your IRA for more than five years, you may withdraw funds to pay ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!