If you’ve heard about the Roth conversion opportunities for 2010, plan now or you may miss something. Here are answers to some questions you may not find in more remedial discussions:
1) Upon converting a traditional IRA to a Roth, what is the amount taxed?
The conversion is treated the same as a distribution (without penalties). The amount taxed is the value of the amount – as if it were distributed. You can also undo a Roth conversion by “recharacterizing” it. The deadline for doing a recharacterization is the extended due date of the tax return for the year of the contribution that is being recharacterized.
2) Upon conversion, can the taxes be paid with money already inside the traditional IRA or 401k accounts?
You can pay the conversion taxes by withdrawing money from your traditional IRA. But doing that will cost you dearly. Example: Suppose you make a partial conversion and owe $5,000 in taxes because of it. You decide to raise that $5,000 through a withdrawal from your IRA beyond what you convert. You’ll pay taxes on the $5,000 withdrawal (in effect paying taxes on top of taxes) plus a 10 percent penalty on the $5,000. If you’re in the 28 percent tax bracket, you’ll have to withdraw nearly $7,700 in order to get the $5,000 to pay taxes on the conversion itself. If you think that’s confusing, you’re right. It’s a reason tax and financial advisors could be in high demand.
3) With respect to the two years to pay the taxes, is the amount subject to taxes added to each of those years or is it all applied to the first years and the two years is just for payment?
Under TIPRA, any conversion that is done in 2010 does not have to be reported on the 2010 return. You will be able to report that income on your 2011 and 2012 returns. For example, if you converted $100,000 in 2010, you would report $50,000 in income in 2011 and $50,000 in 2012. However, if the conversion is done after 2011, you will not be able to spread the tax bill over two years.
4) With respect to creating a traditional IRA with after-tax dollars (non-deductible IRA), then converting it to a Roth in 2010, is there a limit on the amount?
The contribution limits are $5,000 for both 2008 and 2009. If you are age 50 or older, you can contribute another $1,000 that year. Caveat: If you have an existing traditional IRA (with tax-deductible contributions) and you start to fund a non-deductible IRA, then you need to be aware that tax rules state that any conversion is done on a pro-rata basis. Let’s say you had $100,000 in a regular IRA and you had $25,000 in a non-deductible IRA. If you wanted to convert $25,000 to a Roth, then you’d owe taxes on $20,000 because the pro-rata share of your non-deductible contributions is only $5,000.
5) Re #3 above, when is the deadline for doing that with 2009 after tax dollars?
An IRA contribution can be made all the way up until April 15 after the end of the year for which you want to make a contribution. SEP and Keogh contributions can be made up to the due date for filing your tax return — or the extended due date, if you happen to be the procrastinating kind and have requested an extension for filing your return. But, as with so many other things, the first step is the most important. Keogh plans must be set up by December 31, even if you delay making your contribution until later. Both SEPs and IRAs can be established after the end of the year. In fact, the deadline for establishing an IRA or a SEP is the same as the contribution deadline: Tax filing day.
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