Taxes & Penalties

A new federal tax law will eliminate income limits on Roth IRA conversions, enabling all taxpayers — even ones with high incomes — to take advantage of potentially tax-free Roth IRAs. Here are some key points to consider.

  1. The Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA) eliminates income limits on Roth IRA conversions beginning in 2010. You may convert assets from a traditional IRA or other qualified retirement plan, such as a 401(k) or 403(b). The income limits will remain on Roth contributions.

  2. There is no minimum or maximum amount that can be converted. You may make a “partial” conversion of some of the assets in an account to help fine-tune your tax liability.

  3. The amount you convert in 2010 can be included as income in tax years 2011 and 2012. For example, if $50,000 is converted in 2010, $25,000 can be included as conversion income in 2011 and $25,000 in 2012. This applies only to conversions done in 2010. Conversion income can be included on your 2010 tax return if you anticipate an increase in tax rates.

  4. You may convert assets in traditional IRAs and qualified plans, such as 401(k)s or 403(b)s. A conversion from an employer plan must meet the rollover requirements for that type of plan.

  5. If you have made both pretax and after-tax contributions to a retirement account, you must pay taxes on a “proportionate share” of your conversion. For example, if you have $100,000 in an IRA with $10,000 of after-tax contributions, you cannot convert that after-tax $10,000 completely tax-free. Because only 10% of the contributions were made after-tax, only 10% of any conversion will be tax-free. For a $10,000 conversion from that account, only 10% ($1,000) could be converted tax-free. You would be taxed on the other 90% ($9,000).

  6. If you change your mind about a conversion, you may undo it through a “recharacterization,” which returns the assets to a traditional IRA.
    You will receive a refund of any income tax paid on the conversion income. If you have not paid the tax, then the tax liability will be removed. You may do a recharacterization up to the due date of the return plus extensions, which is typically October 15 of the year after the conversion. For example, a conversion done on January 2, 2010 can be recharacterized up until October 15, 2011. If the value of an IRA falls sharply soon after you convert it, you could recharacterize the assets and then reconvert at a lower value to reduce your tax bill.

  7. Reduced account balances mean lower conversion taxes. Once assets are converted to a Roth IRA, they have the opportunity to recover in a tax-free account.

  8. Tax rates are at historic lows. The top rate is 35%, compared with rates as high as 94% in the distant past. Since then, top rates have been as high as 91% in 1964, 70% in 1981, and 50% in 1986. Converting to a Roth IRA may help protect your retirement if rates should rise in the future.

  9. Roth IRA owners are not subject to required minimum distributions (RMDs) and distributions are generally income tax-free. A beneficiary who is not your spouse would be subject to RMDs, but distributions can be stretched over the beneficiary’s lifetime. Those distributions are generally income tax-free.

  10. Distributions of Roth assets (principal and earnings) following conversion can be subject to taxes and penalties based on the owner’s age and how long the assets have been in the Roth. Holding periods begin with each new conversion. The table below provides a summary. State and local tax laws may treat Roth IRAs differently. Consult with your tax advisor for more information.