Roth Conversion Questions

In a comment to May 15’s post, Paul Anonymous raises a number of questions about 2010 Roth IRA conversions. Good man, Paul, you're planning ahead! I’ll try to answer them.

Paul already has both a traditional and a Roth IRA. One question is whether you need to open a separate Roth IRA to hold the assets converted from a traditional IRA, or can you use the existing Roth IRA. The answer is that you don’t need to open a new Roth IRA. One acceptable method for converting a traditional IRA to a Roth is to transfer assets from an existing traditional IRA to an existing Roth IRA. That seems like the administratively easiest thing to do, rather than maintain two separate Roth IRA's needlessly. Although that won’t work if you want to keep the assets at different institutions. Then you’ll of course need separate IRAs.

Paul next asks a question about the wisdom of maintaining a small traditional IRA. Here’s the scenario. Paul apparently intends to convert all (or virtually all) of his traditional IRAs to Roth IRAs. He doesn’t say that explicitly, but that appears to be his plan. And apparently he does not expect to meet the qualification requirements for annual Roth IRA contributions—too much Adjusted Gross Income perhaps. So, looking to the future—2011 and beyond—Paul is planning to make annual traditional IRA contributions and then immediately turn around and convert them to Roth IRAs. Good planning! But that raises the question of whether he should leave some money in a traditional IRA—perhaps a nominal amount—so he doesn’t have to re-open a new traditional IRA every year. I think that’s a terrific idea, as it saves the administrative headache of opening a new account every year--a process that has gotten increasingly burdensome. Keep just enough in the traditional IRA to minimize administrative fees, and then convert the rest to a Roth IRA.

Paul plans to delay his 2009 nondeductible traditional IRA contribution until early 2010. At that point, he will make both his 2009 and 2010 nondeductible traditional IRA contributions, and then immediately turn around and convert them to Roth IRAs. Paul’s thinking is that by delaying the 2009 contribution, he will avoid investment earnings on that amount and reduce the tax cost of converting his whole traditional IRAs to Roth IRAs.

Not so fast, Paulie. I’ve got to disagree with your analysis there. If you keep your $5,000 in your taxable account for the rest of 2009, aren’t you going to earn some returns inside your taxable account—say $50? And then won’t that therefore generate an income tax. In fact, if you invest in interest-bearing investments, the tax you save on the Roth conversion will exactly equal the tax you’ll owe on your taxable investment earnings, so there will be no tax savings at all, plus you will have lost the opportunity to house the $50 inside that most valuable Roth investment environment. Even if you invest in equities, the earnings on which enjoy lower tax rates, the long run benefits of having the $50 inside the Roth environment easily outweigh the short-term detriment of paying a greater Roth conversion tax than a corresponding income tax on the $50 investment earnings. So if I were Paul, I would make my 2009 traditional IRA contribution now, and thereby divert that hypothetical $50 from my taxable bucket to my tax-exempt bucket.

An aside here. It appears that Paul is planning to convert virtually all his traditional IRAs to Roth IRAs in 2010. Would it still be his best strategy to make a 2009 nondeductible IRA contribution if he were planning to convert only a portion of his IRA's to Roths—let’s say 25% of his traditional IRAs? That’s a tougher question. Because then he would only get to recover 25% of his nondeductible contributions tax-free in 2010, and he’d have to wait until later years to recover the remaining 75%. Let’s say he makes a $5,000 nondeductible traditional IRA contribution in 2009, and then converts 25% of his traditional IRAs to a Roth in 2010. The amount he pays tax on is reduced by 25% of his cumulative non-deductible contributions, including the one from 2009. So he contributes $5,000—no deduction—and ends up paying a Roth conversion tax on $3,750. He’s just increased his taxable income by $3,750; he’ll eventually recover the other $3,750 tax-free, but it will take years for that to happen. Is that good planning? I don’t know. I suspect it is, but I think the issue needs some closer study. Look for more on this question in a future post.