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 ROTH IRA CONVERSION UPDATE
December 14, 2009
Payne, Nickles & Company
While the recent tax law change that allows for a deferral of tax on traditional IRA to Roth IRA conversions in 2010 will benefit many taxpayers (see our August 2009 article at www.pncpa.biz), there are some additional factors that need to be considered before deciding if a conversion is right for you.
With Roth IRAs that are funded entirely with after-tax contributions, the contributions can be withdrawn at any time with no tax or penalty. The earnings on those contributions, however, must remain in the account until you are at least 59 ½ and the account has been open for at least five years. The five year clock begins when the initial contribution is made, so if you’ve been contributing every year and you are at least 59 ½ , you can withdraw the entire amount even if you’ve contributed within the past five years. It doesn’t matter if you have been contributing to the same Roth IRA or if you have multiple Roth IRAs.
The five year rule is applied differently to conversions from a traditional IRA to a Roth IRA. For conversions, you cannot withdraw the principal (conversion amount) penalty free until the earlier of five years or age 59 ½ . The five year clock starts running on January 1 of the year of conversion, even if the conversion was made earlier that year. Each conversion has its own five year clock, so if you convert part of your traditional IRA in 2010 and part at a later date, it is important to keep them separate.
If you already have a separate Roth IRA that you’ve funded through after-tax contributions, it will not be affected by the conversion. Even if the conversion goes into the original Roth IRA, the withdrawals are deemed to come first from the contributions, then from the conversion amount, and finally from earnings. The portion that is from the conversion will have a separate five year clock than the contribution portion.
These rules were put in place to prevent someone from avoiding the 10% early withdrawal penalty. In a traditional IRA, if you do not meet the age requirements or one of the exceptions, a withdrawal would result in taxable income as well as a 10% early withdrawal penalty. Without this rule, a taxpayer would have been able to convert from a traditional IRA to a Roth IRA, pay only the tax on the conversion, and then withdraw the Roth principal (conversion amount) with no penalty.
One of the other provisions under the new Roth IRA conversion rules is that if you convert in 2010, you do not have to include any of the income in 2010. Instead, you would report half of the income on your 2011 return and the other half in 2012. For example, if you converted $50,000 in 2010, you would include $25,000 as income in 2011 and $25,000 in 2012. Please be aware, however, that if you withdraw any portion of the conversion amount prior to 2012, the deferral is accelerated and the amount you withdrew becomes taxable in the year of withdrawal. Using the facts from the previous example, if you withdraw $10,000 in 2010 after making the conversion, you would have to include $10,000 as income in 2010, $25,000 in 2011, and $15,000 in 2012.
If you have any questions about how these new rules apply to your situation, please contact us at cpas@pncpa.biz.
Treasury Circular 230 Disclosure -
Unless expressly stated otherwise, any federal tax advice contained in this communication is not intended or written to be used, and cannot be used or relied upon, for the purpose of avoiding penalties under the Internal Revenue Code, or for promoting, marketing or recommending any transaction or matter addressed herein.
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