Conversion Rule Changes
Recent laws change the rules
Rules making it easier to convert to a Roth IRA.
The original rules for Roth IRAs made it difficult or impossible for some
people to do conversions. Here are some changes that liberalize these rules.
Required Minimum Distributions
If you own a Roth IRA, you don't have to take minimum distributions at age 70½. That's
one of the reasons you may want to convert your traditional IRA to a Roth IRA even after
retirement. (For more reasons, see Post-Retirement
But there's a catch. If you're over age 70½, you're already receiving
minimum distributions from your traditional IRA. Those distributions can push your income above $100,000,
to a level where you normally don't qualify for the conversion.
Before 2005, the minimum distribution you
received one year would prevent you from making a conversion to avoid minimum
distributions in later years.
Change effective 2005. A change in this rule appeared in a 1998 law, but with the
effective date postponed until 2005 to make the law comply with some budget
technicalities. Under this provision, you won't have to count your minimum distribution when you
determine whether you qualify for a Roth IRA rollover. You'll still have to take
the minimum distribution, and you'll have to pay tax on it. What's more, you
be able to roll the minimum distribution into your Roth IRA. But the minimum
distribution won't disqualify you from making the rollover, so you can avoid minimum
distributions in future years.
The effect of this provision is to make more people eligible
to convert a traditional IRA to a Roth IRA in retirement. It is significant
only for the years 2005 to 2009, because the income limitation is removed
altogether beginning in 2010, as described next.
Income Limitation for Conversions
For years before 2010, you aren't allowed to
convert a traditional IRA to a Roth if your modified adjusted
gross income is above $100,000. The same $100,000 limit applies
to the overall income of couples filing jointly as singles
(something of a marriage penalty), and individuals who are
married filing separately aren't allowed to do a Roth conversion
at all. The Tax Increase Prevention and Reconciliation Act,
which became law in May 2006, eliminates this limitation
beginning in 2010. If you have a traditional IRA, you'll be
allowed to convert it to a Roth IRA without regard to how much
income you have and without regard to your filing status.
The law includes a special rule for conversions that occur in
2010. For that year only, unless you elect otherwise, income
from a conversion will not be reported in 2010, but instead will
be reported in two equal installments in 2011 and 2012. The
income will be accelerated, however, to the extent you take
withdrawals before 2012.
Implications. This change in the law
has some interesting implications. Consider an individual with
annual income of $200,000. This person can't make a regular
contribution to a Roth IRA — her income is too high — but she'll
be able to contribute to a traditional IRA and then convert to a
Roth. As the law is written, there doesn't appear to be any
obstacle to doing this annually, effectively skirting the income
limitation on regular contributions.
Taking the idea a step further, some advisors recommend that
people in this situation make nondeductible contributions to
traditional IRAs now, in years 2006 through 2009, getting a jump
start on the process. The entire amount built up prior to 2010
will be available for conversion in that year.
In either case, you should bear in mind that the income
component when you convert to a Roth is determined relative to
the total value of all your traditional IRAs. For example, if
you happen to have a traditional IRA with $96,000 of money from
a 401k rollover (zero basis) and you make a $4,000 nondeductible
contribution to a new IRA, thinking you can convert the new
$4,000 IRA to a Roth at little or no cost, you'll be wrong. You
have to add the two IRAs together to determine the taxable
amount, and in this case your conversion would be 96% taxable.
|Possible change. Sometimes a tax law is
amended or repealed before it even takes effect. That's a distinct
possibility here. Congress removed the income limitation on these
conversions because it allowed them to bring this tax law into
compliance with budget limitations. The idea was that more people
would convert to Roth IRAs and therefore pay more taxes in the short
run. (They didn't care about the long run because the budget rules
don't look that far ahead.) There's a possibility that Congress will
take a second look before 2010 and decide this change isn't a good
idea. If that happens, people who made nondeductible contributions
to traditional IRAs may be stuck without a way to convert to a Roth.
Conversion from Employer Plans
Prior to 2008, you aren't allowed to put a distribution from
a 401k account or other employer plan directly into a Roth IRA.
Instead, you have to roll the money into a traditional IRA, and
then convert that IRA to a Roth. You can do the
conversion immediately after the rollover, so there isn't any
point in requiring people to go through this paperwork.
The Pension Protection Act of 2006 changes this rule, but the
change doesn't take effect until 2008. Beginning in that year,
you'll be able to make a one-step conversion from an employer
plan to a Roth IRA. You can do this only if you would have been
able to do a two-step conversion. That means:
- The distribution from the employer plan has to be one
you would be allowed to roll into an IRA; and
- You have to be eligible to do a Roth IRA conversion
(which means, for 2008 and 2009, you can't be married filing
separately and your income has to be below $100,000).
In other words, this is not a change in the substance of the
law, but it is a long overdue elimination of unnecessary
|Types of plans. This rule is not limited to
401k plans. It applies to other types of retirement plan
distributions such as from 403b and 457 plans, provided they are the
type of distribution eligible for rollover to an IRA.