The Roth Conversion Option

The following is an excerpt from The Gospel of Roth: The Good News About Roth IRA Conversions and How They Can Make You Money, a book that argues everyone should convert a Traditional IRA to a Roth IRA. There will be follow-up posts from this book later today and tomorrow to add more details to what is said below. (Update: for more on this topic, see our conversation the other day on whether or not to convert.)

If you follow my advice in the next few pages, you may increase your retirement spendable assets by over 40 percent! Everyone should convert all of his or her IRAs to Roth IRAs on January 4, 2010. (Note: January 4, 2010, is the first date everyone is allowed to convert to a Roth IRA. If you are reading this after that date you should convert as soon as you can following the instructions in this book.) Many articles have been written about the major law change for Roth IRA conversions beginning in 2010. I find most of these articles vague at best, and more often than not, incorrect. Some of these articles are far more confusing than helpful.

Since the inception of Roth IRAs in 1998, you could only convert your traditional or regular IRA to a Roth IRA if your income was $100,000 or less. But, starting in 2010, you can convert your regular IRAs and other retirement plans to Roth IRAs regardless of income. Yes, you read that right—everyone can now convert to a Roth starting in 2010. And everyone should.

FOLLOW THE YOGI BERRA PRINCIPLE

This change in the law has all of the CPAs, financial planners, and engineers scrambling for their calculators and spreadsheet programs debating the virtue of potential Roth conversion for each situation depending on a dizzying array of assumptions about future income tax rates and the maximum number of angels that can dance on the eraser of a number 2 pencil. It is human nature to want to figure out the best answer before taking action; but this intuition is incorrect when it comes to Roth conversions. What you should do is take action, then figure out the best answer. Or to quote the great intellectual Yogi Berra, “When you come to a fork in the road ...take it.” Convert first and calculate later.

The general repeating theme of almost every article about Roth conversions instructs and cautions people to calculate their Roth conversion “suitability” before they make the conversion, implying that a good decision can be made in this order (calculate before you convert). This premise is wrong. Dead wrong. Backwards.

Figuring out if you should convert to a Roth IRA before making the conversion is putting the cart before the horse. Convert first and ask questions later using the method outlined next. Do it exactly this way and I will explain all of the reasons later. The time line for the Roth Conversion Option is as follows:

• STEP ONE: (January 4, 2010, 9:57 am CST.) Convert all IRAs and available retirement plans into new Roth IRAs divided by asset class or investment type. Do not combine or mix with older Roth IRA accounts for now. Keep separate Roth IRAs for assets that were in retirement plans. No single Roth IRA account should exceed 20 percent of the total. If one asset class or investment type exceeds 20 percent of the total divide it into two IRAs or more as needed.

• STEP TWO: (December 3, 2010 at lunchtime.) Recharacterize or unconvert any Roth accounts that lost substantial value from the conversion date of 1/4/2010. These accounts should be converted again to Roth IRAs on January 3, 2011 at 9:57 am CST.

• STEP THREE: (September–October 15, 2011.) Analyze and run your conversion numbers based on all known factors including increases in Roth accounts since the conversions.

• STEP FOUR: (October 17, 2011, 8:30 am CST.) Unconvert or recharacterize any accounts not selected to remain Roth IRA conversions back to regular IRAs.

CINDERELLA STORY

As you can see, you should convert to a Roth IRA first, then run the numbers later. This is because the IRS gives you until mid-October of the year following the year of a Roth conversion to undo the conversion. This “do over” is technically called a recharacterization. Your Roth IRA conversion is not final or complete until you pass this deadline for unconverting or re¬characterizing. To advise a client properly on whether to convert to a Roth IRA is impossible in advance of learning this vital information. You must know about any increase in the Roth account after the conversion date but before the deadline for unconverting to be able to “run the numbers.”

Even folks who otherwise would not ordinarily benefit from the Roth conversion may benefit greatly by converting if the value of the newly converted Roth goes up substantially during this option period. Like Cinderella and her pumpkin carriage, the Roth can be turned back into a regular IRA just as if nothing happened if you choose to do so before the deadline. The only way to have all the options and proper knowledge to make an informed Roth conversion choice is to convert first and ask questions later.

THE DETAILS

2010 is a special year.There is good news on the horizon for anyone with retirement accounts beginning in 2010.The title of this book is The Gospel of Roth. Gospel means good news. This good news or gospel is due to a tax law change that was enacted in 2006 called the Tax Increase Prevention and Reconciliation Act (TIPRA). What a catchy title from a clever Congress. I love it when taxes go on sale, no matter what they call it.

TIPRA changed Roth IRA conversions in two major ways for the year 2010. First this new law allows taxpayers at any income level to convert to a Roth IRA in 2010. In the past, Roth IRA conversions have been limited to folks with an income level of $100,000 or less. Beginning in 2010 and beyond, everyone can convert to a Roth IRA, regardless of income. Notice that this lifting of any income restriction for Roth conversions is not limited to 2010 but applies in the years afterward as well.

Second, for 2010 only, the conversion tax will not have to be paid in 2010, but can be postponed until 2011 and 2012. This law change will produce a remarkable opportunity that is unprecedented. TIPRA rocks.

Comments

[The Biz of Life]

Roth Conversions are a neat little trick for the government to get a bump in revenues short-term. Doing the conversion only makes sense if your current tax rate is lower that you expect your tax rate to be in retirement. They are going to get their taxes out of you one way or the other.

You also have to have a strong belief that the government will not change the rules on Roth IRAs no matter how desperate their financial situation gets in the future.

[Kirk Kinder]

I agree that you need to know that your tax bracket will be substantially lower in retirement. Also, it is best if you are sure your bracket over 2011 and 2012 won't increase. Otherwise, you may pay a much higher tax than if you paid the tax in whole in 2010. Finally, if you plan to donate a substantial portion of your IRA to charity upon death, it may not be a good idea to convert.

I do concur that you should create a converted Roth for each asset class just so you can be sure that you can recharacterize if the asset class loses value between now and October 2011.

[Texas Wahoo]

Quick question. If you make too much to deduct for a tradition IRA, there is absolutely no reason not to start a non-deductable IRA and then immediately convert it to a Roth-IRA. You have to pay taxes on the value anyway, right?

[Apex]

@Texas Wahoo.

That is exactly right. Everyone can either contribute to a Roth and do the non-deductible conversion you mention. And everyone should do one or the other of those. That is a no cost way of getting money into a Roth. Converting existing deductible traditional IRAs is a little more dicey.

[Apex]

I have heard these segmented Roth conversion strategies many times before. On the whole the advice given is sound with respect to the different options and re-characterizations.

It's a big hassle what he proposes and if you have significant money available to do this game with it might be worth that hassle. But just know the mess you are potentially creating for yourself to deal with this. It might be best to get professional help because if you do these re-characterizations wrong, the penalties could be very very painful.

[FMF]

Texas Wahoo and Apex --

I have made non-deductible IRA contributions for a few years and I had hoped I could simply convert those funds (co-mingled with deductible funds from earlier years) to a Roth and pay no taxes. However when I was working through a Vanguard spreadsheet, the form told me that I could not simply convert the non-deductible contributions -- that I had to convert both deductible and non-deductible funds on a pro-rated basis.

I didn't investigate the issue further and maybe I misunderstood, but you may want to look into it a bit more if you're thinking of using this strategy.

[Apex]

@FMF,

You are correct. You cannot "deem" funds segmented after the fact. This strategy only works on segmented funds. The best way is to have a separate IRA for non-deductible contributions and do not mingle them with any previous deductible contributions. Of course any gains will be tax deferred and so those are co-mingled with non-deductible funds and you would have to pay tax on the gains but if the funds were contributed recently the gains will be small and if the funds were contributed anytime in the last 10 years there likely are no gains. :(

So if you co-mingled deductible and non-deductible contributions in the past then yes, unfortunately that does not help you. Going forward, I would suggest a separate account for non-deductible contributions and then convert them as soon after the contribution as allowed (and I don't know if there is a required waiting period or not).

As you can see this new conversion law makes the Roth IRA contribution income caps obsolete but instead of repealing them the just leave in place this arcane method of making a non-deductible contribution and then converting it. And I bet it stays that way for a long time because where is the govt incentive to remove the extra wasted effort?

[Apex]

@FMF,

As a side note to your issue. If you have not made a 2009 non-deductible IRA contribution yet you should do it in a separate non-deductible only account prior to April 15. If you haven't made a 2010 contribution yet you should do the same with that anytime this year. If you have already made both of those contributions then you have no choice but to wait for 2011 to do any non-deductible contribute and convert strategies.

[Jane]

FMF & Apex: Ask for suggestion

I am a faithful reader of this blog. Now I have a question about using non-deductible IRA and converting to Roth IRA and I wonder if you could share your insight on this.

My current financial situation: my family income exceeds the Roth IRA limit for the recent two years. Besides maximizing 401K, we decide to put after-tax money in the company provided saving account, which offers a few index fund choices with very low fees (almost nil). This after tax contribution will be tax free upon withdraw, while its gain will be tax-deferred until withdraw.

I just realized we actually have the option to open a traditional IRA account with after tax money, then immediately convert it to Roth IRA in 2010. Now I am considering this option. This should be a more preferred choice than putting money in the after-tax account with only tax-deferred benefits, right? The only gain I see in that approach is the very low administration fee.

Also, if I still want to catch the 2009 IRA contribution this way but I have already filed the 2009 return, what should I keep in mind during the conversion and tax report?

Could you kindly lend your opinion on this?

[Jeff]

Can I do a Roth recharacterization even if I had activitiy in the account after the initial conversion? Example: convert $1000 cash from a Traditional IRA to Roth, buy stock A in Roth, stock A drops in value 50%, then recharacterize?