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The 2010 Solution

Many successful investors have long lamented that they have not been able to take advantage of the Roth IRA. Many are sitting on significant traditional IRA funds that they have built up over the years or acquired as a rollover from a previous employers

By: Dyches Boddiford

IRA Insights Newsletter

Many successful investors have long lamented that they have not been able to take advantage of the Roth IRA. Many are sitting on significant traditional IRA funds that they have built up over the years or acquired as a rollover from a previous employer’s pension plan. They are frustrated that these funds will be taxed when they withdraw them.

Ever since the Roth IRA became available in the late 1990s, there has been a $100,000 adjusted gross income (AGI) limit on converting traditional IRAs to Roth IRAs. That limit applied to both single and joint filers. For those wanting to make annual contributions to the Roth, their AGI had to be less than $120,000 (2009) if filing as single or $176,000 (2009) filing jointly to make any kind of contribution. These rules mean that many investors are denied Roth IRA accounts altogether.

Well, that’s changing. Back in 2006, Congress modified the law so that beginning in 2010 the $100,000 limit will be eliminated for converting a traditional IRA or other pension plan to a Roth IRA. That means even if your AGI is $5 million, you can convert your traditional IRA to a Roth IRA beginning in 2010! And the conversion rules are not limited to just traditional IRAs. If you have old 401(k)s or other retirement plans from a previous employer, those can be converted as well.

If you opt to take advantage of the new rules, you don’t have to convert all your existing traditional IRA funds to a Roth. There are no limits on how much or little you can convert. Rather, you must decide how much you are willing to pay the taxes on, because whatever you convert is added to your ordinary income for income taxes.

Another BIG benefit of converting in 2010 is that for that one year, the income tax due on the conversion does not need to be paid until your 2011 and 2012 tax returns! That’s right: You can add 50% of your 2010 conversion amount to your 2011 income and 50% to your 2012 income for taxes. This benefit is only available for 2010 conversions. In other years, you will have to pay the taxes for the year that the conversion takes place.

Many of you that did not qualify to deduct traditional IRAs wisely contributed to nondeductible IRAs over the years. Those can be converted without any tax on the initial, nondeductible contributions—you just pay tax on any earnings. This is what I have been doing since 2006 when this new law was passed.

Even if you don’t qualify to make Roth IRA contributions or traditional IRA contributions on a before-tax basis, you can still make after-tax contributions to a traditional IRA for 2009. You can then convert the IRA to a Roth IRA in 2010. And don’t forget that you can also fund a nonworking spouse’s IRA up to the $5,000 limit ($6,000 if age 50 or over).

Let’s look at some examples and the taxes owed. Remember, you only need to pay federal income taxes on the portion of the conversion that you haven’t already paid taxes on.

Example 1: For the past four years, you’ve contributed $4,000 in nondeductible contributions to a traditional IRA. In 2010, you've got $20,000 in your account—$16,000 in nondeductible contributions plus $4,000 is earnings.

In this case, you would only pay income taxes on the $4,000 in earnings when you convert to a Roth IRA. That is the bad news. The good news is that you’ll never have to pay income taxes on this account again.

Example 2: Since 2006, you have made deductible contributions to a traditional IRA.
Because you were able to deduct your contributions from your taxes, when you convert the funds to a Roth IRA, you will owe income tax on the entire account balance: your contributions and earnings.

Example 3: You have a traditional IRA totaling $75,000 funded with tax-deductible contributions as well as $25,000 in an IRA consisting of nondeductible contributions. You want to convert $20,000 to a Roth IRA.

Income tax rules require that a conversion is done on a pro-rata basis. The taxable portion of your conversion is calculated by first pooling all traditional, SEP, and SIMPLE contributions, and then calculating the overall percentage of tax-deferred funds. You pay taxes on that portion of your conversion as opposed to being able to designate that it’s just your nondeductible contributions that you’re rolling over. So if you convert $20,000 to a Roth, you would owe taxes on $15,000, because the pro-rata share of your nondeductible contributions is $5,000 ($20,000 x $25,000/$100,000).

So, in this case, it’s not enough to set up a separate traditional IRA to hold your nondeductible contributions until you can make the conversion. You could convert just that one account, but for tax reporting, any other non-Roth IRAs you have must be factored in when calculating the taxable amount of the conversion.

Okay, some of you want to know if there is a workaround. Well, yes, there is. You can roll your non-Roth IRAs into a non-IRA employer plan. However, you must first check with your current employer about doing this with your 401(k). Be aware that many plans don’t allow it (it was a recent change in the law that allowed this), and they cannot accept any nondeductible IRAs. Also, tying up these funds in your company’s 401(k) can significantly reduce your flexibility in their use.

Another, and better, approach if you have your own business is to open a Solo 401(k) and then roll your traditional IRAs into it. But not the nondeductible contributions—these you will want to convert into the Roth account.

Going forward, there just might be another strategy here. Consider the person with an annual income of $200,000. This individual can’t make a regular contribution to a Roth IRA become of income limits. But he or she can contribute to a nondeductible traditional IRA and then convert to a Roth under the new rules. Currently, there doesn’t appear to be any reason this cannot be done.

Dyches Boddiford is a full-time real estate investor who, along with Peter Fortunato, will be teaching a class on February 20 and 21, 2010 on using self-directed IRAs to invest in real estate. This weekend class will not only cover using your IRA but other people’s IRAs to invest in real estate using basic to advanced concepts.