What You Need to Know About Roth IRA Conversions

by Jason on April 8, 2010

By now you’ve all heard of the opportunity for Roth IRA conversions right?

Ok, but maybe you are unsure what a Roth IRA conversion is all about.

Let’s dispel any myths about this and take a look at exactly what’s going on for this year for Roth IRA conversions.

This post will be more of a lesson in what’s happening than a post to convince you one way or the other to do it.

So let’s jump in!

What is a Roth IRA

First, let’s start with the basics.  I run into quite a few people who are unaware of what a Roth IRA even is.  Most everyone has heard of it, but are simply unsure how it works.

So,  What is a Roth IRA ?  Here’s the basics:

A Roth IRA is an Individual Retirement Arrangement that is funded with after-tax contributions; the money grows tax-deferred; and withdrawals are TAX FREE!

Think of it this way – already taxed money goes in – and comes out completely tax free.

It’s a pretty sweet deal if you qualify, meet specifications and figure that your tax rate will be be higher in retirement than it is right now!

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What is a Roth IRA Conversion

What if there was a way to take money from a fully-taxable account and put it into a tax-free account for life!?

That’s exactly what a Roth conversion is.

You are taking money from a Traditional IRA and transferring it, or converting it to a Roth IRA.

So what happens is you get money out of a position that will be taxable to you in the future and get it into an account that will never be taxed again!

Sounds like a pretty sweet deal right?

Uncle Sam Will Love You and Your Roth Conversion

The problem is that whenever you do this you have to pay taxes on the amount you withdraw from your Traditional IRA for the Roth conversion.

*Uncle Sam pumps his fists!

So let’s say you want to convert $10,000 from your Traditional IRA – you would have to tack that on to your income for the year and pay tax at whatever rate you are at.

It’s as if you earned an additional 10 large for that year!

What Changed in 2010 Regarding Roth IRA Conversions

One big change for 2010 and beyond is that anyone can convert to a Roth regardless of income level.

Previously, if you made over $100,000 you could not convert to a Roth.

Uncle Sam wants tax revenue!  So I’m surprised it’s taken this long to change that rule, but this is the first year.

The other big change for 2010 is that you have a choice to pay all of your taxes in 2010 or average the taxes owed on the Roth IRA conversion over two years ( i.e. pay in 2011 and 2012).

Uncle Sam gives you a choice on when you pay your taxes.

But don’t get fooled, the current tax law plans for higher rates in 2011 - so you’ll possibly be paying for your Roth IRA conversion at higher tax rates!

*Uncle Sam rubs his hands together with a grin!

Things to Consider for a Roth IRA Conversion

 How you will pay the taxes – you don’t want to pay out of your IRA money, so be sure you’ve got some extra cash on the side to pay for it.

Are you over age 70 1/2 – if so, there’s this not-so-little rule about Required Minimum Distributions (RMDs) that must be satisfied first!

What tax bracket are you in? – Will the money you convert push you into a higher tax bracket?  Yikes – better think twice!!

Are you trying to get financial aid? – Whether it’s for you or for your kids, the Roth IRA conversion will count as income on the application!

More Insights into Roth IRA Conversions

For some good insights and varying opinions check out these articles from some fellow bloggers:

Roth IRAs can be great tools to use for retirement – but, be sure to review the rules and regulations to determine whether you should open a Roth IRA and to see if a Roth IRA conversion is right for you.

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{ 8 comments… read them below or add one }

BibleDebt April 8, 2010 at 11:20 am

Good summary of the options. I still like the idea of diversifying between the traditional and Roth retirement accounts. You really don’t know at this point whether your taxes will be higher now or when you retire. If you have some taxed now (Roth) and some taxed later (Traditional), you will not have all of your eggs in one basket.
.-= BibleDebt´s last blog ..Outsource Your Job – Then Catch up on Sleep =-.

Joe Plemon April 9, 2010 at 6:43 am

Thanks for the summary. You helped me better understand the conversion process…I am embarrassed that I did not realize that the rates will jumped in 2011. It will take some shrewd math to compare the incremental rates for 2010 with the newer rates in 2011 in order to determine how much to apply the conversion to for each year. Right?
.-= Joe Plemon´s last blog ..A Prisoner Raises the “Serving Others” Bar =-.

Cedric D'Hue April 10, 2010 at 12:18 pm

Hi Jason,

Thanks for the article. Quick question: My wife and I had traditional non-deductable 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 nondeductable IRAs?


Jason April 11, 2010 at 6:50 pm

Cedric, that is a GREAT question! The answer is it depends if you have other “non-Roth IRA” accounts. If you do, then you have to aggregate all accounts and whatever ratio you have of non-taxable compared to taxable is what you would multiply your conversion amount by. I’ve got a post coming soon on Bible Money Matters that will deal with this in more detail.

Jason April 11, 2010 at 6:58 pm

Joe – thanks for checkin’ in. Yeah, running some numbers and figuring out which will be a better year to pay is key.

Jason April 11, 2010 at 7:01 pm

Bible Debt – thanks and I totally agree, it’s a good idea to diversify yourself from a tax standpoint. Many folks create HUGE retirement time bombs for themselves by plowing everything they can into their 401ks!

JoeTaxpayer April 12, 2010 at 11:04 am

Nice article, thanks for including my guest post at GFC. You know, this is a hot button of mine. Too many advisors are pushing people to do a wholesale conversion that will shoot them into a bracket they’d never otherwise see.
.-= JoeTaxpayer´s last blog ..Introducing Money Mavens Network =-.

Jason April 12, 2010 at 11:08 am

Thanks Joe – I don’t think anyone should push a one-size-fits-all type of strategy for anyone. There are just way too many variables to throw down blanket statements like: everyone should do a Roth conversion or no one should do a Roth conversion.

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