12 traps of Roth IRA conversions
Posted on February 9th, 2010
If the number of phone calls to mutual fund companies and the comments posted to articles on the subject are a sign, savers are showing a lot of interest in converting their traditional individual retirement accounts into Roth IRAs. But they should be careful of acting too hastily, because some expensive traps await the ill-informed.
“Roth conversions can trigger unintended tax traps and financial problems that are not being addressed in the mounds of 2010 Roth conversion information that currently dominates the media,” Ed Slott wrote recently in his newsletter, Ed Slott’s IRA Advisor.
These traps may make you reconsider when to convert, how much to convert or even whether you should convert at all. Here are some of the traps that Slott says await the uninformed:
1. Not knowing that the income is split, not the tax
“While the income limitations for Roth conversions are repealed for 2010 and all subsequent years, 2010 is the only year that will allow taxpayers a special break on paying the conversion taxes,” Slott wrote. “Taxpayers who convert in 2010 won’t have to include any conversion income on their 2010 tax return, and instead will include half the income from the conversion on their 2011 return and half the income on their 2012 return. But just because you evenly split the income over two years doesn’t necessarily mean you evenly split the tax as well. In fact, that would be highly unlikely.”
The total tax bill is going to depend on a number of factors, some totally outside a person’s control, including tax rates and overall income.
2. 60-day rollover mistakes
The best way to move money from an IRA to a Roth IRA is by trustee-to-trustee transfer — a direct rollover. But some company plans or IRA custodians don’t offer this type of transfer, Slott said. Instead, the companies simply write a check to you, the account owner.
In such cases, you have 60 days to move these funds into another qualifying retirement account, including a Roth IRA. And if you don’t make the deadline?
“If the 60 days pass without the funds being re-contributed to another retirement account, the funds become taxable and are no longer eligible for rollover,” Slott wrote.
The only fix for this is a private letter ruling, he said. PLRs, as retirement experts call them, can be costly and time-consuming, and there’s no guarantee the Internal Revenue Service would rule in your favor.
3. Medicare costs and Social Security taxation
You might have to pay higher Medicare premiums or have your Social Security payments taxed if you do a Roth IRA conversion. That can happen if you are receiving these benefits and do a Roth conversion, Slott said.
Roth contribution limits
“In general, Social Security benefits are excluded from the gross income of a taxpayer and are therefore not taxed,” he wrote. “However, depending on how much other income an individual has, anywhere from 50% all the way up to 85% of their Social Security income can be included in gross income, resulting in a higher tax bill for that year.”
What’s more, Slott wrote, “Medicare Part B premiums are based on income. For 2010, joint taxpayers will remain at the lowest premium levels as long as they have income of $170,000 or less ($85,000 for those filing single). From there, premiums progressively increase until joint taxpayers have above $428,000 in income ($214,000 for those filing single). Conversion of a large IRA or plan balance could move you into a higher premium bracket, potentially costing a couple around $6,000 extra in Medicare premiums for 2010.”
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