Ask Money

Roth conversion

Chris Farrell Oct 22, 2009

Question: My wife has a combined income that is over the limit for a traditional IRA tax deduction or for contributing to Roth directly. We both also have employer sponsored retirement plans. Since there is no income limit for conversion from a traditional IRA to a Roth in 2010, I want to establish a traditional IRA now so that I can convert it to Roth next year. My question is, because I will be contributing to my traditional IRA after tax (or without any tax deduction), how I will be taxed when I convert my traditional IRA to a Roth coming 2010? Thanks. Andrew, Norman, OK

Answer: What you’re planning on doing can be a smart move. Let me just give a bit of the background behind your question.

The Roth-IRA is a terrific retirement savings vehicle, probably the best available. The main reason is that all accumulated investment gains are free from Uncle Sam’s clutches when withdrawn during retirement. The other attraction of the Roth is that it offers unusual flexibility for managing finances. For instance, there is no required minimum distribution at age 70 ½ with a Roth as there is with a 401(k) or a traditional IRA.

In the past, you could convert money stashed in a traditional IRA into a Roth, but you could only do it if your adjusted gross income was under $100,000. That earnings cap on conversion disappears next year. That’s why the Roth conversion equivalent of a gold rush is about to be unleashed in 2010. Conversion calculators have sprung up all over the web. (The contribution limits to a Roth and the income phase-outs all remain essentially the same in 2010 and on. What have changed are the rules with conversion.) There are a lot of twists and turns to the Roth conversion question in 2010 and after. But it’s an issue well worth researching.

Now, to your question. Many financial planners I’ve talked to are advising folks that earn too much to contribute to a Roth and a traditional IRA to open up what is called a non-deductible IRA. This is what you’re planning to do. The non-deductible IRA is funded with after-tax dollars. The gain is tax-sheltered over the years and the earnings are taxed at your ordinary income tax rate on withdrawal during retirement.

But you’re not going to wait that long. You’ll convert the non-deductible IRA into a Roth in 2010. The only tax you will owe on conversion is on whatever gain you’ve earned in the meantime–in other words, not much. You won’t owe anything on the contribution since you’ve already paid the tax tab on that money. And, of course, with this maneuver you won’t pay any taxes on the investment earnings when you withdraw the money in your retirement years.

As I said, it can be a savvy move.

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