Because of several Acts signed by the President Bush this past year (the Tax Increase Prevention and Reconciliation Act and the Pension Protection Act of 2006), people saving for their retirement using a traditional IRA, which allows you to deduct the contribution to the account from your taxes, will be allowed to convert those plans to a non-deductible Roth IRA in 2010. The questions are whether the idea of deferred taxes are worth the effort. The short answer is no - unless you have a very small traditional IRA account.
You will be required to pay the taxes on a coverted IRA but these can be spread out over several years. It is best to leave those accounts alone, open a new Roth IRA and let the taxable gains on your traditional plan pay for the gains on your Roth IRA.
Because these types of conversion trigger a tax event, and because this involves retirement accounts, it is important to follow the IRS rules for doing it properly. Otherwise, the failure can be quite costly. Denise Appleby of Investopedia.com offers these suggestions to those of us who are already familiar with the Roth IRA contribution limits and eligibility requirements.
She writes: "some Roth IRA rules, such as those that determine failed or ineligible conversions, are not as well known and could be a trap for the unsuspecting taxpayer. Here we review these rules."
So what exactly causes these types of conversions to fail? The number one reason these types of conversions fail is eligibility. She writes, "A failed conversion is a Roth IRA conversion for which the Roth IRA owner did not meet the eligibility requirements. There are several ways a Roth IRA conversion could fail."
Many of these problems take place, according to Appleby when investors try to play the market and in doing so, "individuals recharacterize conversions with the intention of reconverting these conversions when stock prices are lower." She writes that, "Caution must be exercised here as a reconversion that occurs before the allowable time could result in a failed conversion."
She points out that many of the problems arise with the following investor mistakes:
1. The beginning of the year following the year the conversion occurred
2. Thirty days after the recharacterization occurred
Another major reason these types of transactions fail is lack of a simplified tax code. And unless something like this happens, you will need to contact a tax professional for help. If you are using software to do your taxes, ask a trusted friend if they know of someone you can ask.
There are certain statutory requirements such as a modified adjusted gross income (MAGI) requirement for an individual or couple whose MAGI exceeds $100,000 for the year. If you are over this, you are not eligible for a Roth conversion.
Don't overlook the tax-filing status requirement which should concern you if you are an individual who files (his or her tax return) as 'married filing separately'. You are also not eligible for a Roth conversion.
It only gets more complicated from there. Amended tax returns for conversion years might result in an eligible individual becoming ineligible especially if the MAGI or tax filing status changes on the amended return.
There are additional conversion trap doors you could fall through without help and some of them are quite costly. The mistakes range for conversions done before distributions (such as if you are required to take a withdrawal from your IRA). Appleby does point out that, " For tax years before 2005, the RMD amount is added to the individual's modified adjusted gross income to determine eligibility to convert to a Roth IRA. For tax years beginning 2005, this rule is repealed." You might not meet the sixty day requirement.
Whatever the reason, the consequences can force a distribution which is treated as ordinary income. Get help either from the IRA custodian or from a tax professional. There are usually large sums of money involved and although I believe that we can do many investment and retirement moves on our own, this, and many tax situations, are not among them.
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