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What is the point in doing a Roth IRA conversion all at one time?
Old 03-29-2010, 02:13 PM   #1
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What is the point in doing a Roth IRA conversion all at one time?

I seem to be confused. As I understand it, a person can convert any part of his traditional IRA to a Roth IRA for any tax year. But he could also convert all in 2010, but allow it to be taxed one-half in 2010 and the other half in 2011. Now couldn't he just convert one-half in 2010 and the other half in 2011 instead? What is the difference aside from the paperwork of doing it all at once vs. over the two years?

Also, since the marginal tax rate goes up with income, it seems that it could less advantageous to convert a large IRA, since the later parts of the conversion would be taxed at a higher rate than if the conversion were spread over a number of years such that the conversion would be at the lower marginal tax rate.

For example:

Assume someone is in the 15% marginal tax rate with $10K of income to spare until he would hit the 25% marginal tax rate, and has $50K to convert. If he would convert it all in 2010, he would have $20K of income due to the conversion, which would result in for 2010, $10K being taxed at 15%, $15K being taxed at 25%, and the same for 2011, with a net result of:

2 * ($10K * 15% + $15K * 25%) = $10.5K

If instead he spread out the conversion over 5 years, the tax rate would be

5 * ($10K * 15%) = $7.5K

I suppose that if the tax rates would go up, this could make sense, perhaps partially. Or if the person wanted to start taking out a good chunk in 5 years, having the conversion done as early as possible would have some benefit. But aside from that, I just don't understand what the big deal is.

Am I missing something here?
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Old 03-29-2010, 02:56 PM   #2
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What's missing is that those who earned more than $100K in past years couldn't convert at all. And because of their high salary in prior years they weren't able to contribute, so, the account is relatively small.

Oh, and . . . your government needs the $$$.
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Old 03-29-2010, 03:19 PM   #3
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Originally Posted by Gotadimple View Post
What's missing is that those who earned more than $100K in past years couldn't convert at all. And because of their high salary in prior years they weren't able to contribute, so, the account is relatively small.

Oh, and . . . your government needs the $$$.
Couldn't they still do in pieces for now on? Or are you saying that in the future, they will be restricted as well in doing conversions, with this year being the only year that they can do it?
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Old 03-29-2010, 04:04 PM   #4
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Certainly

I think looking at the your current tax bracket ceiling is one of the criteria that should be considered in the conversion.

I think the Roth conversion is a situation where you need to consider a number of factors.

Unfortunately most people (the ones who do not belong here) just look at it on the surface or do what someone else told them
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Old 03-29-2010, 04:17 PM   #5
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I don't see anything important you're missing. My plan is to do chunks of Roth IRA conversion in years when my income is significantly lower than average, and to spread it out.

I suspect however that many people don't have enough in their retirement accounts to need to spread it over many years. And people who use paid financial planners may have incentive to get it done "in one shot" to avoid incurring more financial planning costs than necessary.
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Old 03-29-2010, 04:18 PM   #6
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Quote:
Originally Posted by swampwiz View Post
I seem to be confused. As I understand it, a person can convert any part of his traditional IRA to a Roth IRA for any tax year. But he could also convert all in 2010, but allow it to be taxed one-half in 2010 and the other half in 2011. Now couldn't he just convert one-half in 2010 and the other half in 2011 instead? What is the difference aside from the paperwork of doing it all at once vs. over the two years?

Also, since the marginal tax rate goes up with income, it seems that it could less advantageous to convert a large IRA, since the later parts of the conversion would be taxed at a higher rate than if the conversion were spread over a number of years such that the conversion would be at the lower marginal tax rate.

For example:

Assume someone is in the 15% marginal tax rate with $10K of income to spare until he would hit the 25% marginal tax rate, and has $50K to convert. If he would convert it all in 2010, he would have $20K of income due to the conversion, which would result in for 2010, $10K being taxed at 15%, $15K being taxed at 25%, and the same for 2011, with a net result of:

2 * ($10K * 15% + $15K * 25%) = $10.5K

If instead he spread out the conversion over 5 years, the tax rate would be

5 * ($10K * 15%) = $7.5K

I suppose that if the tax rates would go up, this could make sense, perhaps partially. Or if the person wanted to start taking out a good chunk in 5 years, having the conversion done as early as possible would have some benefit. But aside from that, I just don't understand what the big deal is.

Am I missing something here?
If you choose to convert half now and half next year the tax will be different because the gains or losses between this year and next year will be different.

Next year that $50K IRA may be worth $60K or $40K. So, "are you feeling lucky punk?"

Actually it is not quite so much a gamble because you could convert your $50k in January this year, and if the market falls and by December it is worth $40K you can "recharacterize" it. (ie change your mind and put it back to a regular IRA - at least I think you can)
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Old 03-29-2010, 09:15 PM   #7
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If you choose to convert half now and half next year the tax will be different because the gains or losses between this year and next year will be different.

Next year that $50K IRA may be worth $60K or $40K. So, "are you feeling lucky punk?"

Actually it is not quite so much a gamble because you could convert your $50k in January this year, and if the market falls and by December it is worth $40K you can "recharacterize" it. (ie change your mind and put it back to a regular IRA - at least I think you can)
I see your point. I suppose that one would need to have cash on the side to pay the taxes - it wouldn't seem prudent to cash out of the 401K early just to take advantage of a conversion. Hmm ... I need to do more pondering ...
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Old 03-30-2010, 12:06 AM   #8
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Originally Posted by swampwiz View Post
Couldn't they still do in pieces for now on? Or are you saying that in the future, they will be restricted as well in doing conversions, with this year being the only year that they can do it?
This is expected to be the only year where the $100K limit is exempted. Of course Congress could always pass a new law as part of their repair of all the other tax breaks that expire this year.
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Old 03-30-2010, 12:52 AM   #9
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This is expected to be the only year where the $100K limit is exempted. Of course Congress could always pass a new law as part of their repair of all the other tax breaks that expire this year.
Nords....do you have a link to that? I thought the only thing special about 2010 was the option to split the conversion income to 2 future yrs. Hadn't heard about the 100K limit being a one-time special.
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Old 03-30-2010, 09:06 AM   #10
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Yes I thought the 100K limit was gone for good(or until they passed another law) but it was only this year that you could split the taxes over 2 years.

The government needs money, I would imagine there is a lot of cash flow going to the government due to the roth conversions, that previously the government would not have gotten a piece of until 59 1/2 or later.

Might be short term thinking on the government part, but ...........
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Old 03-30-2010, 09:42 AM   #11
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In 1998, when the 4 year conversion was allowed, only 25% of all folks that were eligible converted to Roths. It was quite a surprise to the Congresscritters, who were sure everyone would do it.

Everyone is trumpeting the conversions because of the 2-year window open now, but a lot depends on your state. Here in Wisconsin, the state did not enact legislation that follows the fed guidelines, so the folks that do Roth conversions without consulting their tax advisors are going to be pretty pissed with their 2010 returns........
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Old 03-30-2010, 10:41 AM   #12
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Originally Posted by kaneohe View Post
Nords....do you have a link to that? I thought the only thing special about 2010 was the option to split the conversion income to 2 future yrs. Hadn't heard about the 100K limit being a one-time special.
I agree. I think the limits are gone starting in 2010.

RothIRA.com - Resources and Information About Roth IRA's
Quote:
Starting in 2010, the existing $100,000 income test for converting a traditional IRA to a Roth IRA no longer applies. Conversions that occur in 2010 will be able to have half of the taxable converted amount taxed in 2011 and the other half taxed in 2012
2010 Roth IRA Conversions

Quote:
But back in May of 2006 President Bush signed a $70 billion tax cut provision that changed the eligibility rules for Roth IRA conversions. Starting in 2010, taxpayers with modified adjusted gross income of more than $100,000 will be allowed to convert a traditional IRA to a Roth IRA. This change applies to all years beyond 2010 - and the income taxes due on the 2010 conversion can be spread over two years. So the 2010 conversion amount may be included as taxable income in 2011 and 2012 - helping to spread out the tax bite. Conversions in subsequent years are included in income during the tax year in which the conversion is completed.

Removing the Roth IRA conversion cap however doesn't mean anyone can fund a Roth IRA, but it does mean that anyone can convert an existing IRA to a Roth IRA.
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Old 03-30-2010, 05:36 PM   #13
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Nords....do you have a link to that? I thought the only thing special about 2010 was the option to split the conversion income to 2 future yrs. Hadn't heard about the 100K limit being a one-time special.
I apologize, I'm wrong here.

I thought the $100K MAGI conversion limit was part of all the other tax breaks set to expire in 2010. However re-reading Fairmark (Conversion Rule Changes) with your question in mind, I understand now it's not explicitly stated. The two-year tax payment is only for 2010, but the removal of the $100K MAGI limit appears to be a permanent change to the conversion rules.

And since it speeds up tax revenue for the Treasury, I can understand why Congress did it that way and probably won't mess with it...

I can also understand why Congress would also let the rest of the earlier tax reductions lapse without any further action.
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