Conversion of IRA to Roth IRA prevents Roth IRA contribution?

[Guest ptb]

Since my company has no plans to offer a Roth 401(k), I thought I could achieve nearly the same thing by:

1. Contribute $15,000 to a regular 401(k)
   
2. Convert $15,000 from my regular IRA to a Roth IRA
   

I waited until the end of the year to be sure that my Modified AGI remained below $100,000 (excepting the conversion amount). And, knowing that I'd owe more income taxes, I made plans to make an estimated tax payment for 2006 on 1/15/07.

As I worked through the number with TurboTax 2006 (which is available now, although subject to additional updates), I discovered two things that I didn't anticipate:

1. The converted $15,000 raised my MAGI high enough to partially reduce my maximum contribution to my Roth IRA for 2006.
   
2. My income tax withholding for 2006 is slightly less than what I paid in 2005, so I'm potentially liable for a penalty for underpayment.
   

I'm going to try using the annualized income worksheet, and if that doesn't help -- request a waiver. Hopefully, since I was only a couple of hundred bucks short, the penalty won't be large.

But, my real question is: did TurboTax correctly forecast the reduction in what I can contribute to my Roth IRA this year (aside from the conversion)? Or did i enter the wrong code in box 7 of the 1099-R? I used "2": early distribution (except Roth), exception applies.

Or is there something else that I need to do, so that the amount converted from regular IRA to Roth IRA is not added to MAGI, when determining the amount I can contribute to a Roth IRA?

[Guest allancoleman]

I'm not a tax expert as many here , ptb , but I've done a few Roth conversions and I use TurboTax too . In my distribution box #7 , in the ' distribn code(s) 1st code box ' , I put a numerical ' 7 ' as was stated on my 1099 for past years I've done Roth conversions with the same custodian . There was also an ' X ' marked in the " ira/sep/simple ' box . When I've used those codes , the next question TurboTax asks me , " Is this a Roth conversion " . And , of course , that's exactly what it is . Also don't forget to fill out a form 8606 for the amount of your conversion amount .

When I've used all of the above , I've found that the Roth conversion is added to my income as a distribution with no penality . And , of course , when all my 1099's show up in my mail next year , I double check to make sure the codes i'm plugging in now agree with the real thing I get next year . I like to use TurboTax as a planning tool , just as you're doing now , before year's end here in a couple of weeks while I still have time to change some other parts of my tax return before year's end .

When I first started doing Roth conversions , I had the same difficulty paying enough taxes on my quarterlies to cover the additional taxes owed on my conversions . But , after i've done a few it gets easier . I usually slightly over pay to make sure there isn't a problem .

[txdd]

Roth conversion income is excluded from Modified AGI for Roth IRA purposes so there should be no reduction in your Roth contribution limit.

[John G]

I guess I have a question about the process. You apparently have funded a 401k (regular, not Roth) for 15,000 and now want to convert that to a Roth. Have you checked that you company 401k allows you to flip the assets out of the plan? If that is not allowed by the plan, I don't think what you propose will work.

If that is not a problem, understand that you will have to act very, very fast because the 401k needs to be transferred to a custodian and the custodian must then do the conversion before the end of this month if you want it to apply for 2006. Custodians and plan holders get very busy in the last two weeks of the year, so you need to monitor the progress of anything you request. If the transfer has not yet started, you chances of getting this done in 9 business days is at best 50/50.

If your company is not offering a match for the current 401k, you could directly fund a Roth with 4,000 of you after-tax income. And, yes, you could do both.

[Guest ptb]

In my distribution box #7 , in the ' distribn code(s) 1st code box ' , I put a numerical ' 7 ' as was stated on my 1099 for past years I've done Roth conversions with the same custodian . There was also an ' X ' marked in the " ira/sep/simple ' box .

Allan, thank you very much -- this was the key. I didn't read the "help" carefully on the separate question about whether the IRA/SEP/Simple box was checked, and clicked "no". I went back and clicked "yes" instead, and it all came together.

Earlier this morning, I realized that I must has missed something, because I didn't remember specifying that the distribution was converted to my Roth IRA. I was about to investigate it further when I found the reply notification in my e-mail.

I'm going to pay estimated tax each quarter to avoid any penalties in 2007. I applied for a ID at eftps.com, to make it easier.

Thanks for your help!

[Guest ptb]

You apparently have funded a 401k (regular, not Roth) for 15,000 and now want to convert that to a Roth.

John, I have taken a distribution from my regular IRA and done a conversion into my Roth IRA. I'm not making any changes to my 401(k).

[Guest allancoleman]

No problem , ptb . I've been using TurboTax for years so it comes alittle easier to me now . The first couple of years , I struggled with TurboTax too . Last tax year ( 2005 ) , my effective tax rate was 15% . This tax year it's looking like it'll be 14% . I could probably easily get it to 13% in the future . And this is with conversions of over $100k a year . I love Roth conversions and it's going to make my RMD later much easier to live with .

John G brings up an excellent point that the deadline for conversions is calendar year's end and NOT next April as with contributory Roths .

I think there is an IRS regulation coming on line shortly in the next few years that would allow us to transfer money straight from a 401(k) to a Roth and skip the traditional IRA conversion phase , and I'm really looking forward to that , but it ain't here yet .

[Guest ptb]

I love Roth conversions and it's going to make my RMD later much easier to live with.

At the risk of turning this into a political discussion, my reason for doing so is the expectation that income tax rates must be raised about the time I retire. My crystal ball is as cloudy as everyone else's, but I just don't see any alternative, unless a miracle occurs.

John G brings up an excellent point that the deadline for conversions is calendar year's end and NOT next April as with contributory Roths.

The conversion is already done. I have a regular IRA created from a 401(k) rollover when I changed jobs a few years ago. My goal is to gradually transfer some of it into my Roth IRA every year, while keeping my marginal tax rate at a reasonable level.

I waited until last week, to be sure I was under the 100K MAGI limit. Fortunately, the limit is being lifted in 2010, and it won't be a factor after that.

[Guest allancoleman]

Agree with you , ptb , that future income tax rates'll have to go up . But , even without that , if I didn't start my Roth conversion strategy years ago , I was faced with a RMD that would have kept me in the highest tax brackets forever after 70 1/2 .

I usually do my Roth conversions in the fall of every tax year when I've pretty much got my income figured out for that year .

Good luck on your Roth conversions . I can't believe they haven't messed with'em yet . It's going to allow me to be a millionaire and take distributions and NOT pay any income taxes . . It don't get any better than that .

[John G]

My mistake, I missed the 15K was coming from an IRA. Its goof to hear that you already did the conversion, so the year end rush will not be a factor.

I too suspect that future tax rates may drift higher. Our story is a little unusual, but we have lots of friends in nearly the same situation.

As a professional planner I am the first to admit how difficult it is to project even 5 years into the future. My wife and I are non-traditional professionals with virtually zero pensions, annuities or insurance. As my wife is a PhD candidate and I am semi-retired, we have minimal payroll income. That means we now rely completely on our taxable investment assets. At some point (my wife will be a professor for perhaps a decade) our retirement expenses will be met by a combination of taxable brokerage assets, IRAs and Roths.

In 2000, I did a six screen Excel spreadsheet of our financial future to project how an escalating stream of annual expenses might be met by a combination of social security, small pension, stock investments, IRAs and Roths. After three years, I had to completely overhaul the 2000 plan because of positive changes in annual returns, my wife going back for her PhD (never expected by me), and new involvement in real estate partnerships. I probably need to completely overhaul it again next year. By setting up the spreadsheet with various toggles and assumptions, I was able to test scenarios. Some observations from our scenarios: social security will never be more than 10% of our annual income, we never run out of money before age 95 unless annual returns average under 5% and coupled with an expense inflation rate of over 5%, our retirement income is likely to look a lot like our best years, although tax free Roth distribututions could be a substantial part of income each year our taxable income will be substantially into six figures, under all normal scenarios we have the capacity to help other family members or make community bequests, and depending upon the scenario and tax policy we may have estate planning issues.

In '94, I "retired" from the normal work world to focus on investing and private ventures. My wife and I converted about 2/3rds of our IRAs in 1998 in part because we expected to be top bracket in future years. In our scenarios, the deductions and exemptions diminish and the taxable income stays far above 100k, so we don't expect a drop in tax rates. Although those assets have gone through some choppy times, we have had put our best investments in the Roths and have averaged around 17% annual returns. We are both 55 and don't expect to draw down on the Roth funds for another 15 years, and possibly much later. We are comfortable with a hybrid 25/75% IRA/Roth.

PS: I think that you have a 50/50 chance of the 2010 rules getting changed. There are just too many revenue/budget/deficit issues that need to be addressed by Congress and some of the recently passed tax legislation left odd gaps. Another area that is likely to change is the inheritance tax rules that jump back and forth in different years.

[Guest allancoleman]

Right now , John G , my deferred accounts ( 70% ) to Roth accounts ( 30% ) ratio is fairly comfortable , but I intend to keep my Roth conversion strategy in place as long as it makes financial sense . In the end , with RMD and conversions , all my deferred accounts will be depleted . Roths will be my last money spent . Then I'll be 100% Roths and one happy camper . I just hope they don't change the law before I can get more than my " 30% Roth foot " in the door .

I agree with 100% of your post and want to thank you guys over here for all your very professional answers . Keep up the good work .

[Guest mjb]

One Q on Roth conversions. As I understand it, Roth contributions increase AMT exposure because the contributions are taxable income unlike pre tax contributions which decrease AMT taxable income. If someone is subject to AMT why would they make a Roth contribution? When unlimited roth conversions are permitted in 2010 will not the additional taxable income result in AMT exposure?

Pretax contributions reduce taxable income which allows greater itemized deductions for med expenses and misc. expenses and reduces 3% haircut on itemized deductions for high income taxpayers. Congress is unlikely to repeal the unlimited roth conversions b/c of the revenue to be gained in 11 and 12.

Roth conversions are still subject to the time value of money equation b/c the opportunity cost of the lost income on amounts used to pay taxes reduces the amount of tax free income generated by the roth, e.g., 1000 in taxes @8% = 2000 in 9 yrs, 4000 in 18 yrs, 8000 in 27 yrs, 16,000 in 36 yrs, etc. Roths make sense for persons who will be in a higher tax bracket when the amounts will be withdrawn or for those persons who want to reduce their estate tax exposure by the amount of income tax paid on the conversions (although there is an income tax deduction on taxable payments equal to the pro rata amount of estate taxes paid on the IRA).

[Guest allancoleman]

Agree with you , mjb , about the ' time value of money ' . However in my own personal situation years ago I found that I would be facing the same similar circumstance as " MountainMan " who has excessive funds in deferred accounts and was facing very large RMD . I will be in the highest tax bracket , forever , after age 70 if I don't do Roth conversions now in a lower bracket . Sometimes too much money can be a problem too . But , it's a good problem .

Can't answer your question on contributory Roths because I've only done Roth conversions and they've never triggered AMT . And I have experienced AMT once when I got alittle carried away with excessive real estate write offs years ago . And I learned never to do that again . . Another reason I like TurboTax is because I get a good read out from them if I've triggered AMT or not . And TurboTax has excellent forward planning tools for future returns .

Agree with you , mjb , that Roth conversions aren't for everyone . But they've really been a good thing for me .

[John G]

Lots of folks are borderline AMT but may not know it because they don't do the calculations. My accountant has been giving me a large tax return each year with AMT calculations even when they don't apply. I crossed the line 1 year, but have been flirting with the boundary for a decade.

AMT, Roths, and inheritance tax regulations will be under Congressional review. I think there is some sentiment for changing the AMT since it was originally conceived to "catch" the ultra rich who sometimes paid no taxes. Well, that plan didn't work. There are still folks who don't pay taxes and the AMT is now getting triggered my too may middle class families. Because the deficits/war/entitlements all interact and we have a new Congress - it is not possible to know which rules will get changed and what compromises will be made. Even the minimum wage fits into the picture.

Watch for changes. Do not expect "magic" windows like 2010 to go unchanged.

[Guest mjb]

There is an estimator in the 1040 instructions and on line at the IRS web site that indicates whether there can be AMT exposure. For persons who have paid AMT in prior yrs it is best to max out pre tax contributions to lower AMT.

Despite talk by congrressional democrats, AMT reform is hilghy unlikely without overall tax reform b/c AMT is concentrated in about mostly blue states that have high income/property/sales taxes, e.g., NY,CA, NJ, MA, CT, IL, MD and high concentrations of residents with taxable income in excess of 100k. Reps and Senators from the other 40 states are unlikely to vote for AMT reform which will increase taxes on their residents. There is not much sympathy for persons making 150k who are subject to AMT. Eliminating the tax will cost 900B over 10 yrs. Estate tax changes will not be considered until after the 2008 elections b/c of a veto to any changes in currrent law. Roths are a rev gainer for the gov so it unlikely that they would be curtailed.