Conversion Must Be Qualified: As most of you know, a conversion from a regular IRA to a Roth IRA is possible if certain conditions are met. First, the conversion must be qualified. The term "qualified rollover" can get a little complex, but it is basically a rollover that meets the 60-day rollover time period, and is not in violation of the "one-year" rollover rules. For additional information regarding qualified rollovers, check out IRS Publication 590 at the IRS website.
Adjusted Gross Income Limitations: Assuming you can get over the "qualified" distribution rules, you still have one other hurdle to clear -- the Adjusted Gross Income (AGI) limitations. The law states that if your AGI is greater than $100,000, you may not convert from a regular IRA to a Roth IRA.
This $100,000 limitation applies not only to single filers, but also to married people filing jointly and head-of-household filers. Furthermore, don't think you can beat the AGI limitations by filing a married-separate tax return. You can't. The law specifically states that if you are a married taxpayer filing a separate tax return, you may not convert your regular IRA to a Roth IRA… regardless of your AGI.
(Note: So, what if you made a Roth conversion in January 1998 and now find that your AGI will exceed the $100,000 limitation? First, don't panic. You have the ability to "re-characterize" your Roth IRA back to a regular IRA without penalty if you follow a few simple steps. Second, read more about how to follow those steps in my article in the Taxes articles archive entitled "Roth IRA Conversion Issues." Check it out.)
And remember that the AGI limitations are computed without regard to the amount of the conversion. An example here might be appropriate.
Example: Jack, a single person, has 1998 AGI of $75,000. Jack also has a regular IRA in the amount of $60,000 that he wants to convert to a Roth IRA. For AGI limitation purposes, Jack's conversion threshold is $75,000 (the amount of his "normal" AGI, without regard to the conversion amount), and not the total of his "normal" AGI and his "conversion" amount. Jack's AGI for income tax purposes will change if he decides to make this conversion, but that's an issue that we'll discuss in detail a little later.
Conversion Taxation Issues
OK… you've decided that you can make a Roth conversion. Now you need to know more about the tax issues involved in making the conversion.
In effect, the funds converted from the regular IRA to the Roth IRA that would have been taxable had the distribution not been part of a qualified conversion will be subject to income tax at your normal tax rate… plain and simple. If your IRA consists only of prior deductible contributions and the earnings thereon, the total amount of the conversion will be subject to taxation.
If part of your IRA consists of prior nondeductible contributions, they will not be taxed again at the time of the conversion.
And if your IRA consists of funds from a prior rollover from another qualified pension plan (such as a pension/profit sharing plan, 401(k) plan, 403(b) plan, Keogh plan, SEP plan, etc.), all of the funds will be taxable to you at the time of the conversion -- with one major exception:
Roth conversion income spread: The law says that if your Roth IRA conversion takes place before January 1, 1999, the amount required to be included in income as a result of the conversion may be included in gross income ratably over the four tax-year period beginning with tax year 1998. Or, alternatively, you may elect to take the conversion income all in 1998. The choice is yours. Just remember that this "spread out" option only applies to conversions made on or before December 31, 1998. If you decide to make a Roth IRA conversion in 1999 or later, you are free to do so, but you'll be required to report the conversion income in the year of conversion… in total. You'll lose the potential tax-saving benefit of "spreading out" the income over four tax years.
This income (spread out or not) will impact any and all tax issues that are based on AGI… except for any current or future Roth contribution and/or conversion issues. But your medical expenses (7.5% AGI floor), miscellaneous deductions (2% AGI floor), taxability of social security (based on AGI), passive loss limitations (based on AGI), and many other tax provisions that use AGI as a guidepost will be impacted -- in some cases, severely impacted. So this must all be taken into consideration when you decide whether or not you want to "spread" your income, or if you even want to make a Roth IRA conversion at all.
No penalty: Because the conversion is "qualified," the 10% penalty for an early withdrawal from an IRA account will not be imposed. In effect, the conversion can be made without paying the 10% IRA early withdrawal penalty. But should you decide to remove these converted funds "early" from the Roth IRA, you may be subject to a penalty. We'll discuss the penalty issue in detail next week.
Confused? No need. Let's continue with the example of Jack and his conversion.
Example: Jack's 1998 AGI is $75,000, and he wants to make a $60,000 conversion from his regular IRA to a Roth IRA on or before December 31, 1998. For 1998, Jack's AGI for income tax purposes will be either $135,000 (his regular AGI of $75,000 plus all of his conversion income of $60,000) or $90,000 (his regular AGI of $75,000 plus one-quarter of his Roth IRA conversion income of $60,000, which amounts to $15,000). It's Jack's choice. But let's assume, for the purpose of this example, Jack decides to spread out his conversion income over the four-year period.
In tax years 1999, 2000, and 2001, Jack will add an additional $15,000 (representing the "spread out" of his 1998 conversion) to his normal AGI, and will pay tax on that "spread out" income at his normal tax rate for those years. And the spread out of this income will also impact his AGI issues for those years (medical deductions, miscellaneous deductions, taxability of social security, etc.). So Jack's decision to spread the income will certainly impact his taxes for the next three years. Which is why this could be a very important decision.
But remember also that if Jack delays his Roth IRA conversion until 1999, this additional $60,000 conversion income could not be spread out -- it would have to be added to his normal 1999 AGI and would be taxed in total in 1999. The "spread or not" decision is only available for 1998 conversions. But, in either case, Jack would not be hit with a 10% early withdrawal penalty on the amount of the IRA converted to the Roth IRA (assuming Jack keeps his nose clean and doesn't take the funds out of his Roth IRA "early").
Finally, as noted above, all of the tax issues that use AGI for a benchmark (except Roth contributions and conversions) will now be based on Jack's new 1998 AGI, whatever that amount happens to be depending on Jack's election to "spread" or not.
So, Jack can look forward to paying more tax dollars to Uncle Sammy over the next four tax years. In effect, Jack is trading tax dollars now for the tax-free status of the Roth earnings in the future. Is that appropriate? Perhaps for Jack, based on his personal situation, the answer is yes. But it is not necessarily appropriate for everybody. In fact, for some people, the conversion of a regular IRA to a Roth IRA may actually cost them tax dollars in the long run.
That is why the Roth IRA conversion debate has now become very heated. The decision to make this conversion is one that is very personal, based on personal status, goals, age, intentions, etc., etc., etc. Therefore, the "conversion or not" question can only be answered by you, based on your personal financial and tax situation. You can find various "calculators" all over the Web to help you with your decision. You can also check out other sites that deal with Roth conversion decision issues. Two of the very best would include the Fairmark tax site Fairmark tax site and the Roth IRA site. Before you make your final conversion decision, you should take the time to read what these sites have to say about the pros and cons.
Next we'll look at distributions from a Roth IRA and what impact those distributions may have on your personal tax situation.
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