This is the first in a series of Tech Updates, in question and answer form, on issues relating to Roth IRAs. We will cover a range of issues including 2010 law changes, plan to Roth IRA rollovers, Roth IRA conversions, recharacterizations and reconversions, and taxation issues associated with Roth IRA transactions. This Part 1 discusses the 2010 law changes, and how the changes apply to a conversion of a traditional IRA to a Roth IRA. Part 2 will address similar issues on a conversion of a pre-tax plan distribution to a Roth IRA.

Q-1: How did the law change regarding conversions to Roth IRAs?

Before 2010, a taxpayer with modified adjusted gross income (AGI) exceeding $100,000 could not make a qualified rollover contribution to a Roth IRA from a traditional IRA or a non-Roth account in a retirement plan. Neither could a taxpayer who was married but filed a separate return. Beginning January 1, 2010, Congress has eliminated the AGI and filing status limitations on a qualified rollover contribution to a Roth IRA. A rollover to a Roth IRA from a pre-tax IRA or plan account is referred to as a “conversion." As a result of the law change, any taxpayer can convert to a Roth IRA.

Q-2: How do I convert a traditional IRA to a Roth IRA?

A taxpayer can convert a traditional IRA to a Roth IRA by one of three methods: (1) take a distribution from a traditional IRA and contribute the distribution to a Roth IRA within 60 days of receipt; (2) direct a trustee-to-trustee transfer of an amount from the traditional IRA trustee to the Roth IRA trustee; or (3) direct a transfer of an amount from a traditional IRA to a Roth IRA of the same trustee (or transfer the entire account simply by redesignating the traditional IRA as a Roth IRA). Some IRAs refer to the IRA holder as a “custodian" rather than a “trustee." The conversion rules apply the same to either a trustee or a custodian.

Q-3: What are the tax consequences of converting a traditional IRA to a Roth IRA?

Subject to a special taxation rule for 2010 conversions (see Q&A-4 immediately below), the taxpayer must include amount of the conversion in gross income for the taxable year in which the amount is distributed or transferred. However, the law reduces the amount the taxpayer must include by the taxpayer’s “basis" (after-tax amounts). For this purpose, the taxpayer computes the value of the IRA at the end of the calendar year (increased by any distribution during the calendar year, treating any conversion by transfer as a distribution for this purpose). In determining the basis recovery amount, a taxpayer must aggregate all of the taxpayer’s IRAs. If the taxpayer has only pre-tax IRA dollars, the entire amount converted is includible in income. If the taxpayer has any basis in any IRA, the taxpayer must determine the basis recovery (non-taxable) portion of the Roth IRA conversion.

Example #1. Jill has 2 IRAs. The IRAs consist solely of pre-tax dollars. Jill converts $30,000 of the IRA 1 to a Roth IRA (IRA 3) on March 1, 2012. As of December 31, 2012, the remaining value of IRA 1 is $90,000, and the value of IRA 2 is $80,000. As a result of the conversion, Jill must include in her gross income $30,000, the amount of the conversion.

Example #2. Assume the same facts as in Example #1, except that as of December 31, 2012, IRA 2 consists of $20,000 basis (resulting from prior years’ nondeductible contributions) and $60,000 pre-tax dollars. For purposes of determining Jill’s taxable income, her total traditional IRA balance is $200,000 ($90,000 in IRA 1 and $80,000 in IRA 2 on December 31 + $30,000 distributed during the year) and her basis is $20,000. So, 10% ($20,000/$200,000) of her distribution is basis, in this case $3,000 out of a $30,000 distribution. Jill must include $27,000 in her 2012 gross income as a result of the 2012 conversion. It does not matter whether the basis is in IRA 2 or IRA 1.

Note that a taxpayer under age 59½ is not subject the 10% premature distribution penalty at the time of the Roth IRA conversion, but may be subject to the penalty if the taxpayer takes a nonqualified distribution within 5 years of the conversion. A later Tech Update in this Roth IRA series will discuss the application of this penalty.

Q-4: Is there a special taxation rule that applies for 2010 conversions?

Yes. To encourage taxpayers to take advantage of the conversion opportunity, any amount includible in gross income as a result of a 2010 conversion will be includible ratably in 2011 and 2012 – 50% in each year – unless the taxpayer elects to pay taxes on the conversion amount in 2010. Although deferral of taxation generally is to a taxpayer’s benefit, the possibility of income tax rate increases in 2011 or 2012 may cause some taxpayers to decline the deferral of taxation and to include the conversion amount in 2010 income.

Q-5: Does the law change discussed in Q&A-1 mean that I can begin contributing annually to a Roth IRA without regard to my income?

No. The law still imposes a limitation on contributions to a Roth IRA based on a taxpayer’s adjusted gross income. The IRS adjusts this income limitation annually based on cost of living increases. For 2010, the limitation for a married taxpayer filing a joint return is $167,000, and for a single taxpayer is $120,000. If the taxpayer’s adjusted gross income exceeds this limitation, he/she still cannot make a Roth IRA contribution.

Note that this limitation does not apply to a participant in a Roth 401(k) or Roth 403(b) plan. A participant in a Roth plan may make Roth contributions, subject to statutory and plan limits, without regard to income.

Q-6: If my adjusted gross income prevents me from making a Roth IRA contribution, can I still take advantage of the Roth conversion rules?

Yes. A taxpayer literally can convert a traditional IRA contribution to a Roth IRA the day after the contribution, subject to the taxation rules discussed in Q&A-3 above.

Example #3. Doug earns $200,000 in 2010 and is an active participant in his employer’s 401(k) plan. Doug therefore cannot make a deductible IRA contribution and cannot contribute to a Roth IRA. On February 1, 2010, Doug makes a $6,000 nondeductible contribution to a new IRA. On February 2, 2010, Doug converts the IRA (still worth $6,000) to a Roth IRA. If Doug has other non-Roth IRAs, he must determine the amount includible in gross income using the basis recovery principles discussed in Q&A-3. If Doug has no other IRAs (e.g., because he always has made his retirement plan contributions to a 401(k) plan), there are no further tax consequences to Doug as a result of the conversion, since he already must include the nondeductible IRA contribution in his 2010 gross income.

We will discuss the Roth conversion process at the Advanced Pension Conference. In addition, Roth IRAs, conversion and related IRA issues will be the subject of ERISA Newsletter 2010-1. We also have added Roth IRA conversion and recharacterization forms to ERISA Forms. The ERISA Newsletter and ERISA Forms are part of The Pension Library.