Can I Divide an IRA Conversion Over Three Years?
Original post by Mark Kennan of Demand Media
Having money in a tax-deferred retirement account, such as a traditional IRA or 401k plan, benefits you most if you anticipate paying a higher rate of income tax the the current year than in your retirement years. If the opposite is true, you may consider converting the money to a Roth IRA so that you can pay the taxes now and avoid them on your distributions. Knowing how you can structure your IRA conversion helps you minimize your resulting income-tax liability.
IRA Conversion Function
When you convert money to a Roth IRA, you choose how much of the money in the account you want to convert. For example, if you have $90,000 in your traditional IRA, you can choose to convert $90,000 all in one year or to break the conversion into smaller chunks, such as $30,000 per year over three years. When you convert smaller portions, you reduce the chances that the extra taxable income for the year will push you into a higher income-tax bracket.
Advantages to Converting Over Time
Roth IRA conversions result in additional income taxes because the amount of the conversion counts as taxable income. If you try to convert the entire amount of the account at once, you may find yourself without funds to pay the resulting taxes. If you use money from the conversion to pay the taxes, you lower the value of your Roth IRA. In addition, if you are not yet 59 1/2 years old, the IRS charges a 10 percent early withdrawal penalty on the money. When you space the conversion over a longer period of time, such as three years, you give yourself more time to pay the resulting tax.
Disadvantages to Converting Over Time
Once you convert the money into your Roth IRA, the amount continues to grow tax-free and you do not need to pay income taxes on the earnings ever again. By converting the entire amount in the first year, all future growth is tax-free. If you space the conversion over a few years, the earnings on the converted amounts get taxed when you eventually convert them. For example, if you have a $60,000 traditional IRA and you convert $20,000 in the first year, that $20,000 in the Roth IRA can grow without ever being taxed. However, if the remaining $40,000 grows to $44,000 before you convert the next year, you would have to include that $4,000 in earnings on your income taxes if you convert the remainder of the account.
Special Exception for 2010 Tax Returns
If you converted money to a Roth IRA during the 2010 tax year, a special exception allows you to complete the conversion over three years. This exception allows you to make the conversion in 2010 and then pay half the resulting income tax in 2011 and the other half in 2012. This exception was available only for individuals completing a Roth IRA conversion in 2010.
- Internal Revenue Service: Publication 590
- Internal Revenue Service: Retirement Plans FAQs Regarding IRAs
- Schwab Bank; 2010 Roth Conversion: Look Before You Leap; Rande Spiegelman; 2009
About the Author
Mark Kennan is a freelance writer specializing in finance-related articles. He has worked as a sports editor for "Ring-Tum Phi" and published articles on a number of online outlets. Kennan holds a Bachelor of Arts in history and politics from Washington and Lee University.
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