Roll Out Your IRA, And You'll Save A Barrel of Taxes

Minimize Taxes On Your 2010 Roth Conversion With An IRA Roll Out

January 1, 2010 kicks off the Roth Conversion season.  If you plan to convert next year, have you considered rolling some of your IRA money into your 401(k) or 403(b) account at work to save some taxes?

Instituted as part of The Tax Increase Prevention and Reconciliation Act signed into law by President Bush on May 17, 2006, taxpayers earning more than $100k finally have the option to convert their IRAs and other eligible retirement accounts to a Roth IRA starting in 2010.  Please note that this opportunity was included in that Tax Act as a REVENUE-RAISER.  Yes, the government hopes to collect a lot of tax revenue thanks to high-income individuals who convert their IRAs and other qualified retirement accounts to a Roth IRA in 2010.

"In our March 2007 Newlsetter available at http://www.findagoodcpa.com/2007news/news0307.php, we instructed our readers to begin (or continue) making non-deductible contributions into their IRAs each year in anticipation of converting their IRA to a Roth IRA in 2010.   The higher the percentage of post-tax dollars to the total value of your IRAs, the smaller the tax burden on the amount converted.  Remember, you should have been tracking your post-tax contributions on a Form 8606 attached to your federal income tax return," explains Andrew Schwartz CPA, founder of FindAGoodCPA.com (www.FindAGoodCPA.com), a site where taxpayers can locate a CPA in their metropolitan area based on the CPA’s specialty.

A Few Examples

Let's look at an example of how you will be taxed on a Roth conversion, assuming you currently have only one IRA account funded with $23k of non-deductible IRA contributions going back to 2006.  If your IRA is worth $30k on the date you convert it to a Roth IRA, you will owe taxes on $7k of income (FMV of $30k less post-tax contributions of $23k).  That's not too terrible of a tax hit to end up with $30k in a Roth account growing tax-free.

But what happens if you also have a rollover IRA or SEP IRA worth $200k?  In this example, since your post-tax IRA contributions remain at $23k while your total IRA value jumps to $230k, your basis in your IRAs falls to just 10% of your total IRA balance ($23k/$230k).  If you convert your $30k IRA to a Roth IRA, you now only shield $3k of the amount converted from taxes, and should expect to be taxed on $27k of income.

Taxability of a Roth Conversion

Save Taxes With a Roll Out

If you have made non-deductible contributions to your IRAs over the years, you might be able to save significant taxes on your Roth conversion by taking advantage of this strategy included on page 23 of IRA Publication 590, Individual Retirement Accounts (IRAs) available at www.irs.gov:

Tax treatment of a rollover from a traditional IRA to an eligible retirement plan other than an IRA.  Ordinarily, when you have basis in your IRAs, any distribution is considered to include both nontaxable and taxable amounts. Without a special rule, the nontaxable portion of such a distribution could not be rolled over. However, a special rule treats a distribution you roll over into an eligible retirement plan as including only otherwise taxable amounts if the amount you either leave in your IRAs or do not roll over is at least equal to your basis. The effect of this special rule is to make the amount in your traditional IRAs that you can roll over to an eligible retirement plan as large as possible.

Basically, the IRS is reminding you in their Publication 590 on IRAs that you have the option of rolling money out of your IRAs into an employer sponsored plan that accepts IRA rollovers.  And when you roll money out of an IRA, the non-deductible contributions remain within the IRA.

In the second example above, what would happen if that person rolled his $200k Rollover IRA into his 403(b) account at work?  In this updated example, the total fair market value of his IRAs would revert to just $30k, so the taxable income on the conversion would be the same $7k as in the first example.  This person's taxable income, therefore, would decrease by $20k.  That's a pretty good return on your investment of a few minutes of time spent completing some paperwork.

One way to push this opportunity even further is to convert the exact amount of the post-tax IRA contributions you made over the years, and roll out the remaining IRA balance into your 401(k) or 403(b) account at work.  This strategy allows you to get the maximum amount of money into your Roth IRA without paying a dime of taxes.  Please read through the instructions to Form 8606 available at www.irs.gov if you are skeptical of this strategy.  You also need to check with the retirement plan administrator at work to confirm whether your employer's 401(k) or 403(b) plan accepts IRA rollovers.

"I think that famous Polka tune heard frequently on the Lawrence Welk Show sums up this opportunity the best: Roll out your IRA, and you'll save a barrel of taxes....," sings Schwartz.

Website Resources

For the very latest tax and basic financial planning information, visit www.FindAGoodCPA.com.