How to convert to a Roth IRA and pay little or no income tax
By John Azoddi
Azodi CPA & Investment
In a previous article, I explained that there are two ways to set up a Roth IRA. The first one is called a contributory (or regular) Roth IRA.
The second way to have a Roth IRA is through a Roth IRA conversion. This is for those people who already have an existing IRA. You can convert all or part of your IRA to a Roth IRA; however, by doing so, you are required to pay tax on the amount that is converted.
Once converted, it acts like a regular Roth IRA, and offers the same features. If you consider doing a Roth IRA conversion, the conversion must be complete before December 31. The tax is due in the year the conversion is completed. To qualify for the conversion, your adjusted gross income (AGI), without counting the Roth IRA conversion and RMD from a regular IRA if you are older than 70½, has to be less than $100,000. Your AGI is the total of all income, less certain adjustments. It is shown on the last line (37) of page one of your Form 1040 tax return. Alternatively, it is on line 21 of page one of Form 1040A.
However, the IRS is allowing everyone to convert his or her IRA into a Roth IRA in the year 2010 without the AGI limit. The best part is that you have two years to pay the tax on this conversion. Why? Well, Congress is giving high-income earners a chance to obtain a tax-free Roth IRA because of a phase-out.
You may ask, "Why should I convert my IRA into a Roth IRA and pay tax on it now? Isn't the biggest reason for investing in an IRA in the first place so that I can defer the tax for as long as possible?"
It is true that for many, this is not the right thing to do, but there are conditions that may justify converting. I will explain some of them.
You should convert your IRA into a Roth IRA under the following conditions:
Example 1: You have created negative taxable income. You create negative taxable income when your deductions exceed your income. Let's say your negative taxable income is $9,000 and you have $100,000 in an IRA. You could convert $9,000 to a Roth IRA and pay no income tax. The earnings of your converted Roth IRA will now grow tax-free. Why is this? According to the IRS rule, you have technically paid tax on the $9,000 by reporting it as income. The fact that your deductions have wiped out the tax does not matter. In the eyes of the IRS, you have paid tax on this money. The following are some of the conditions that may cause you to have negative taxable income:
- You have lost your job and have been living off of your savings; therefore, you have very little income for that year.
- Near the end of the year, you realize that your itemized deductions (sum of certain deductions) or the standard deduction if you don't itemize (which was $11,400 for a married person in 2009) was more than your income.
- There are many similar cases to the one above. Another example may be that you have income, but you may incur major medical expenses or have donated substantial amounts of money to charity or paid a large state tax for a prior year's income. Any of these can increase your itemized deductions and thus cause negative taxable income.
Example 3: The most common circumstance I have seen for conversion from an IRA to a Roth IRA is for retired seniors between the ages of 59½ and 70½. Many live on Social Security, pensions, and/or their investments that are not taxable and have very little taxable income. Even though they have large IRAs, they are not taking money out until age 70½, when they have to start their required minimum distribution.
For instance, a married couple could have $18,000 income and pay no income tax at all, because the IRS allows them $18,000 of deductions. Social Security is not taxable unless, if added to all other forms of income (including interest from municipal bonds, even though municipal bond interest is income tax-free) it is more than $25,000 for a single person or $32,000 for married people. In this case, up to 85 percent of Social Security could become taxable.
So, if taxable income becomes negative, it makes sense to convert. The only issue is that you have to be proactive about it. This means that you have to look at your taxes and decide whether you will have negative income before the end of the year. Also, if you convert, the converted part of the IRA could cause some of your Social Security income to become taxable. You must do a "what if" calculation of your taxes before you convert. Do not guess. Don't allow your CPA or tax preparer to tell you how much you can convert without doing a mock tax return if Social Security income is involved.
There are other times when it makes sense for seniors or others to convert to a Roth IRA, even if they have to pay tax on it. Here are two such examples.
Example 4: You are currently in a 10 percent or 15 percent federal tax bracket (you have to count the state income tax percentage if you live in a state that has income taxes) and you know that by the time you take money out of your IRA, you will be in a higher tax bracket, such as 25 percent or higher. In this case, you may want to convert as much of your IRA as possible before your taxable income changes to the next bracket. The amount of tax you pay should come from other assets to pay the tax. If you do use the money from your IRA to pay the taxes, the conversion portion would be only the amount invested. If you are younger than 59½ and convert, you must pay the tax from other money. If you use the money from an IRA to pay the tax, then you must pay the 10 percent penalty on the portion used to pay the tax, in addition to the income taxes. I do not usually recommend this for someone under age of 59½ if they have to pay a penalty.
Example 5: You have a large IRA and want to leave it for your children. You know they will pay tax on it, and their tax rate is higher than yours. Then it makes sense to convert. You may accomplish three things with this conversion: You do not have to take a RMD from your IRA after you turn 70½. Your children can stretch a Roth IRA and receive a lifetime of tax-free earnings versus a lifetime of income that is taxable, if they use the IRS RMD table and did not take more money than the RMD tables allow. Depending on the size of your estate, you could save estate tax. (Discuss this with your CPA, estate attorney, or financial advisor with expertise in estate planning, as this would require expert advice.)
What happens if you convert your IRA into a Roth IRA and when you are preparing your income taxes you realize it is costing you too much in tax or that you went over the $100,000 adjusted gross income limit? The IRS allows you to reverse the conversion without any tax consequences once per calendar year before the due date of your tax return, plus the maximum six-month extension period (whether or not the return is actually extended). This is called a Roth IRA recharacterization. For example, the deadline to recharacterize a 2010 Roth conversion is October 15, 2011.
By converting, you will be reducing your IRAs, which means, after you turn age 70½, your required minimum distribution would be less.
Has the value of your IRA investment gone down?
If yes, then there's another reason for you to convert now! If you convert an IRA account that has lost money, you now will pay tax on the lower value. If and when your account recovers, the earnings will be tax-free. Of course, there is still the risk that your account could decrease in value, even as a Roth IRA. However, you are given one opportunity to change it back to a regular IRA by your tax filing deadline, plus extension (October 15th, of year after conversion) and avoid paying any income tax.
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