Q&A on Roth IRA Conversions

From the December 20. 2009 Wall Street Journal

Roths: Your Questions, Our Answers

By ANNE TERGESEN

Our recent column about tax rules that are about to give more people access to a Roth individual retirement account prompted many questions from readers.

Starting Jan. 1, those with modified adjusted gross incomes of more than $100,000 will, for the first time, be allowed to move assets held in traditional IRAs to Roth IRAs.

Marc Rosenthal

Individuals with modified adjusted gross incomes of $120,000 or more -- and couples with $176,000 or more -- will still be barred from contributing to Roths. But anyone willing to pay the income taxes due upon converting assets held in a regular IRA to a Roth will be able to funnel retirement savings into a Roth, where it can grow tax-free.

Here are answers to some reader questions:

Q: Can you convert an inherited IRA, a SEP IRA, or a 401(k) account?

A: You can't convert an inherited IRA. But you can convert a 401(k) account and a Simplified Employee Pension, or SEP, IRA, which is typically offered by small-business owners. If you are still working for the company that sponsors your 401(k), ask whether the plan allows "in service" distributions, says Ed Slott, an IRA consultant in Rockville Centre, N.Y. If so, you can convert this money to a Roth.

Q: Will Roth conversion taxes trigger the alternative minimum tax?

A: Those who get hit with the alternative minimum tax, or AMT, typically claim deductions that are high, as a percentage of their income. Since you must pay income taxes on the IRA money you convert, your taxable income goes up.

So, people already subject to the AMT may find that converting causes their income to rise by enough to get them out of paying the AMT, Mr. Slott says. (The IRS requires taxpayers to pay the higher of their regular income tax or the AMT, a parallel federal income-tax system that operates under many different rules than the regular system.)

But it can work in reverse. A small conversion, for example, might raise your taxable income enough to make you subject to the AMT. If a person is hit by the AMT, he or she might want to convert more of their IRA dollars, Mr. Slott says. That's because in the AMT, the maximum tax rate is 28%. Mr. Slott notes that, for many of his clients, that's a lower tax rate than they would pay on converted money in a year in which they aren't hit by the AMT.

Q: We have capital losses. Can we use them to offset taxes incurred upon converting?

A: Gains and losses on capital assets, which are typically stocks and bonds, can offset one another. So, if you have $30,000 of capital losses, you can use them to offset up to $30,000 in capital gains. But in a given year, you can only use up to $3,000 of capital losses to offset your ordinary income. As a result, if you convert to a Roth, you can only use capital losses to offset up to $3,000 of that income. But you can carry forward unused losses to offset income in future years -- though the $3,000 annual limit will still apply.

Q: I have been contributing the maximum to a traditional IRA on an aftertax basis. If I convert it to a Roth, will I have to pay taxes?

A: Under the "pro rata" rule, you can't convert only your nondeductible contributions. To estimate your potential tax bill, first calculate your "basis."

Expressed as a percentage, this is the ratio of two numbers: the aftertax contributions you have made to your IRAs, and the total balance in all your IRAs. For example, if you contributed $40,000 aftertax to your IRAs and have a total of $250,000 in those accounts, your basis would be 16% (or $40,000 divided by $250,000). So, if you plan to convert $100,000 to a Roth, 16% of that $100,000 (or $16,000) could be transferred tax-free.

Q: How do I determine what my pretax and aftertax contributions have been?

A: Most 401(k) plans will keep track of this for you, Mr. Slott says. But when it comes to IRAs, you're supposed to file Form 8606 in years when you make nondeductible contributions. On the form, there's a line that requires you to add the current year's nondeductible contribution to those from prior years.

If you haven't filed this form, check your brokerage or bank statements for the years you made IRA contributions. Then, look at your tax returns from those years. If you don't see an IRA deduction, then you can probably assume you made a nondeductible contribution, he says. Don't bother looking back further than 1987 since that was the first year nondeductible contributions were allowed.

Q: If I am 59½ or older, can I withdraw contributions tax- and penalty-free within five years of a Roth conversion?

A: Yes. Once you are over 59½ , the only reason you would need to wait five years is to withdraw the earnings tax-free.

Q: Could Congress decide to tax earnings that build up in Roth IRAs?

A: Yes. But the odds are greater that Congress would raise tax rates, Mr. Slott says. Of course, higher tax rates would be bad news for traditional IRA owners -- who are required, after age 70[frac12], to start withdrawing money from their IRAs and paying income taxes on the distributions.

Because Roth conversions -- and the taxes due on those conversions -- bring money into the Treasury, Mr. Slott says he believes Congress likely would be reluctant to close down that money maker.

Email: encore@wsj.com

Write to Anne Tergesen at anne.tergesen@wsj.com