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Roth Conversion and the Pro-Rata Rule

Thursday, May 6, 2010   

Roth IRA conversion is one of the hottest investing topics of 2010.  Since the IRS lifted the ban on Roth conversions for $100k+ earners at the start of the year, scores of articles have been written about whether to convert.  For many investors, the answer lies in understanding the simple but all-important pro-rata rule that the IRS uses in determining your conversion tax.   

Briefly, Does Conversion Make Sense for Me?

Roth IRAs are attractive because they allow you to pass along tax-free assets to your heirs, they don’t have required minimum distributions (RMDs), and they provide a means for tax diversification in retirement (a hedge against potential tax policy changes).  Of course, when you convert, you’ll owe taxes on prior tax-deductible contributions, and the income from conversion could bump you into a higher tax bracket or cause you to miss out on valuable tax credits.  Generally speaking, Roth conversion makes the most sense for those who won’t withdraw the money for several years (better yet, decades), and for those who expect to be in a similar or higher tax bracket upon withdrawal.  Vanguard’s Roth IRA Conversion Calculator is a handy tool for running some scenarios based on your unique situation, but if in doubt, it’s best to consult your tax advisor.

The Impact of the Pro-Rata Rule

The most common questions that I get about Roth conversion relate to avoiding the large upfront tax bill.  Those who have made past nondeductible contributions wonder if they can convert just the nondeductible portion of their IRA, while others ask if they can make a new nondeductible contribution and immediately convert it to a Roth.  There’s nothing illegal about these tactics, but in most cases, the pro-rata rule will prevent you from getting away tax-free.  This rule requires that each distribution from an IRA contain the same proportions of taxable and non-taxable assets as your total IRA balance (rollovers, SEP-IRAs, SIMPLE IRAs, etc).  In other words, you can’t cherry-pick which assets you want to convert.  The rule is best explained with an example.

Let’s say that Sam has $100,000 in total IRA assets, $20,000 of which came from nondeductible contributions.  Because of the pro-rata rule, any partial conversion will be considered 80% taxable and 20% tax-free, the same proportions as Sam’s total IRA balance.  If Sam wishes to convert $20,000 to a Roth IRA in 2010, he will owe taxes on 80% of $20,000, or $16,000.  If he’s in the 28% tax bracket, that’s a $4,480 federal tax bill.

Of course, there are a couple of ways that Sam could avoid this sticky rule.  If his employer-sponsored retirement plan allows rollovers from IRAs, Sam could roll the $80,000 taxable portion of his IRA into his employer plan and then convert the remaining $20,000 to a Roth IRA without owing taxes.  He could also look at his wife’s IRA situation.  If her IRAs have a higher percentage of nondeductible contributions, it might make sense to convert her IRA assets before his.  Again, it’s probably best to check with your tax advisor if it sounds like these tactics might work for you.

Conclusion

There’s a lot of hype about Roth IRA conversion, but for most investors, the decision is far from a no-brainer.  Hopefully, a better understanding of the IRS pro-rata calculation will allow you to make a more intelligent decision about converting in 2010.

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Posted by George | IRAs & 401(k)s | Comments (0)
 

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