Tax-Free Roth Conversions, for Some

Everyone loves the idea of a Roth IRA. How could you not want the ability to withdraw decades of compounded gains tax-free? If you believe that income tax rates are headed higher, and they definitely are for those in the top brackets, a Roth is even more compelling.

None the less, the single biggest obstacle stopping folks from converting traditional, SEP, or SIMPLE IRA assets to a Roth is the taxes they face. In the year you convert, income tax is due on any amounts that have not yet been taxed. These include annual contributions that you were able to deduct and accrued earnings. (1)

For instance, say you have $100,000 in a traditional IRA: $70,000 represents contributions you made and $30,000 is from the earnings on your IRA investments. Thus, you have never paid income tax on any of the money. If you’re in the 33% income tax bracket and convert half your account- $50,000- you have to come up with $16,500 to cover the additional income tax you’ll owe.

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However, if, like a lot of folks, you lost the ability to deduct your IRA contributions
because your income was too high, then your IRA probably consists of a mixture of pre-tax assets (earnings + deductible contributions) and after-tax assets (non-deductible contributions). Herein lies the opportunity.

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For instance, assume that your traditional IRA breaks down as follows:

Traditional IRA:

Earnings: $30,000

Deductible Contributions: $20,000

Non-deductible Contributions: $50,000

Total: $100,000



If you have a retirement plan such as a 401(k) through your employer, your conversion could be tax free.

First, some background. Federal legislation passed in 2001 introduced the concept of “portability:” the ability to move retirement assets from one type of account to another. Portability is supposed to make it easier to manage and track your nest egg if you’re able to keep it all in one place. So, for instance, if you leave your job at the hospital, you can roll your 403(b) account into the 401(k) offered by your new employer- provided the plan allows this- and vice versa.(2)

The key is that IRAs can also be rolled into company-sponsored retirement plans. However, as Brooklyn, New York CPA Barry Picker points out, “As a matter of law, you can only roll over pre-tax money.”

In the previous example, you have $50,000 of pre-tax money (earnings + deductible contributions) in your traditional IRA. If your employer’s plan accepts rollovers from other retirement plans, you would roll this into your 401(k).

The end result? You now have a traditional IRA holding only $50,000 in after-tax assets. Since you previously paid income tax on this money, you’re not taxed again. The entire $50,000 can be converted to a Roth IRA tax-free.

“We recommend this strategy,” says Picker, of the firm Picker and Auerbach. “It’s an excellent idea.”



1. The “gift” of allowing you to postpone paying income tax on a 2010 Roth conversion is a Trojan horse: if you take the government up on its offer and report half of the taxable portion of your conversion as 2011 income and the remainder as 2012 income, the amount of tax you pay will be based on whatever rates are in effect in those years. If your tax rate is higher, this approach will cost you more