The significance of the 2010 Roth IRA conversion rule change and its impact can not be overstated. While the Roth IRA income limits remain in effect for new 2010 contributions, the IRS eliminates the income limit on Roth IRA conversions, and that’s essentially the same thing as eliminating the income restrictions on making a Roth IRA contribution.

Why?

Because if you make too much to contribute to a Roth, you can simply max out your Traditional IRA with non-tax deductible contributions and then convert it to a Roth IRA!

If you intend to use withdrawals from your traditional as a source of income (as I do), then you need to consider what you will do if say, you need 20k for a new roof. If you withdraw 20k + income taxes from your traditional for that purpose, then you have just permanently reduced your future annual withdrawals, or you have just permanently reduced the probability that you will not run out of money in your lifetime.

I expect to have enough to live modestly in retirement, but I do not expect to have enough to live lavishly in retirement. For this reason, the prospect of permanently reducing my income each time I have a big-ticket expense does not appeal to me.

Therefore, I have opened the Roth. I plan to eventually use it to pay for large home maintenance expenses and vehicle replacements. In this way, I can pay for my new roof, owe no additional income tax, and leave my annual income intact.

Oblio #2 – No, the value of your conversion does not put you over the 100k limit. According to IRS publication 590, your “modified AGI for Roth IRA purposes” is your AGI as shown on your return and then modified. One of the listed modifications is subtracting Roth IRA conversions. There are other additions and subtractions, so please refer to publication 590 available at irs.gov.

For (3), the answer is no — that’s the entire tax advantage of a Roth IRA. You pay income tax, then you contribute to the Roth IRA, and then that money isn’t taxed again — not while it earns interest and not when you take distributions after retirement.

1. When I convert from a Traditional IRA to a Roth IRA will I have to pay taxes on just the basis (my yearly contributions)or will I be taxed on the basis and the earnings?

2. When I choose to convert (before 2010) is the full value of the Traditional IRA I’m converting added into the calculation of my modified adjusted gross income. In other words, can the value of the Traditional IRA I’m converting put me over the $100,000 eligibility limit?

3. Lastly, are my Roth IRA yearly earnings taxed?

i started in 2006

I agree that the future might not be kind to us as savers. We can’t expect the same rules to apply in 20-30 years (for me) upon retirement. However, if changes such as the ones you described ever come to pass, then all the more reason to save as much as possible now (even in a Roth IRA) to offset such effects! I’m not going to avoid investing (in a Roth) to protect myself from the possibility that some of it might be taken away later. Not only Roth distributions, but all sources of retirement income will be worth less (but not worthless)! It encourages me to make sure I’m investing even more!

And, with regards to Social Security benefits, I hope that we (at least those in my generation) plan to NOT have it in retirement. In my eyes, whatever might be still allotted by then would just be “the cherry on top,” but not at all depended on to sustain my desired lifestyle in retirement.

But with the current and past ‘Govmint’ spending that is going on, not only will tax rates increase, but other ways to tax Roth’s will come into effect. One would be a ‘national sales tax’ if that ever came into play then all the Roth monies that are supposed to be tax free will now be taxed as you spend it.
Another could be a means test for future Social Security benefits. If you have $$$ in money available then your SS benefits get decreased by $$.

As said above, no one will know what the future brings, but I am planning the best I can with what we have available now.

Good question. It actually does not change the progression. Whether and how much you go with the Roth option on your 401k is an independent decision, although I would imagine it would be influenced on whether you are maxing out your Roth IRA. The only thing to keep in mind is that employer matches are, as far as I know, always deposited into your 401k as traditional contributions (pre-tax).

1) contribute to 401k until employer stops matching
2) max out Roth IRA contribution ($5k this year)
3) max out 401k ($16.5k this year)
4) contribute to normal taxable investment account

Now, that said, you probably have some target (like 50-50) that you would like to hit across your Roth accounts and pre-tax accounts. There will be a optimum strategy to minimize the risk of being way off that target if you care to get this detailed. Let’s say your employer matches up to 10% (just to keep the math easy). I would suggest this:

1) contribute $1650 to Traditional 401k
2) max out Roth IRA contribution ($5k this year)
3) contribute $3350 to Traditional 401k
4) max out 401k, contributing 50% to Roth option ($16.5k max this year)
5) contribute to normal taxable investment account

That way if you end up not being able to max out your 401k, you’re at least 50-50 across Roth and traditional accounts.

I’ve seen that general progression before, and makes good sense to me. But what if your employer also has a Roth 401k plan as well, where would that fit in the sequence?

Currently I’ve got an employer match of 6%, and I’m putting 13% each in Trad 401k and Roth 401k. Its time to change it up.

My question is, how would the IRS determine I screwed up and possiblly owed some money? Would it be in the 1 or 2 years following the time I did that, or would they somehow figure it out when I started the withdrawals down the road?”

Putting money into an IRA is putting money into an IRA. You’re not putting deductible or non-deductible money in. Whether your deposit into the IRA is deductible or not is determined when you file your taxes. You choose whether to claim the amount as a deduction (or not) at that time. If you take the deduction in one year, but not the next year, then you need to keep track of the amounts that you did not claim (non-deductible amounts) so that when you withdraw them later you know you already paid taxes on that amount (and you’d pay taxes on any gains – but cannot deduct any losses). Anybody out there think I got any part of this wrong?
The IRS won’t be coming after you. They’re happy to have you make non-deductible contributions because you’re paying taxes on that income and not getting a deduction. If you’re not deducting the amount because you’re over the Roth limits, you can convert the non-deductible portion to a Roth in 2010.
Ok, having said all that, you really need to read books about IRAs when you’re putting real money into them. That way, you’ll know up front what you should or shouldn’t be doing – based on your own particular situation.
Good luck – and keep good records (like your IRS Form 8606, which I believe shows deductible and non-deductible amounts each year).

Understood, but what about the opportunity that Roth accounts provide in the event that regular tax rates go up to 50% to pay for the Congress’ and Presidents’ deficit spending, but they DON’T cancel the tax exemption on Roth withdrawals. Roth conversions would be even more valuable under that scenario. Which is more likely? My crystal ball is on the blink… so I’ll diversify and have both Roth and non-Roth accounts (and invest to protect against inflation, primarily, because I believe the deficit spending is baking inflation into our long-term cake). Hope for the best, plan for the worst!

To all: If you have IRAs or 401ks worth more than, say, $10k (and certainly if worth more than $50k), you should be reading published materials about IRAs written by experts (not just asking us fallible, mere mortals). I benefited from reading Ed Slott’s book “Parlay Your IRA into a Family Fortune” because in addition to IRA basics it deals with stretch IRA estate planning. Remember, try your local library first, and try to ensure the books you choose were written in the last two years to ensure current laws are discussed.

To go back and find your nondeductible contributions, compare all your 1040s to your Form 5498s. Form 5498 reports all IRA contributions, so if you take that total, less what was deducted on your 1040 – you should get your nondeductible amount.

Well there’s a risk of something similar with any financial product, as all financial products are really just legal constructs. There’s been lots of proposals the last few years to remove the tax benefits of 401ks but they haven’t gone anywhere.

I do see this kind of possibility as more likely as government benefit programs increase, but that’s making a political prediction and to me that’s difficult if not impossible past a very short time window. The winds blow, things change. As the U.S. becomes more like a European country, if that’s how it goes down after all, I can see things like a wealth tax being levied as there have been calls for that too for some time now.

Of course it’s interesting to note that some nations have implemented and gotten rid of wealth taxes in what amounts to cycles for various reasons, so again you can’t really say what’s going to happen.

All a person can do is act on what they know to be true, today. Most of us think too much of our own capacity for geopolitical/economic analysis, and even the political scientists and economists can’t seem to get it quite right.

The general advice is to do the following in order until you don’t have any more money to save:
1) contribute to 401k until employer stops matching
2) max out Roth IRA contribution ($5k this year)
3) max out 401k ($16.5k this year)
4) contribute to normal taxable investment account

The last will incur a lot of transaction costs, so you probably don’t want to be doing dollar cost averaging…

I don’t really know which to choose…I’m just below the income requirements for Roth, but I don’t know if that will be the case a year or two from now…

My question is, how would the IRS determine I screwed up andpossiblly owed some money? Would it be in the 1 or 2 years following the time you did that, or would they somehow figure it out when i started the withdrawals down the road?

Thanks for the ongoing articles about Roth IRA’s; this one is particularly clear and helpful. I need to get off my butt and open one. I’m not willing to convert my current IRA’s since I don’t want to pay the tax on them all at once and I’ve no idea what tax bracket I’ll be in 30yrs from now. However my employer’s 401k provider just passed around a survey in which one question was about interest in Roth 401k’s. My answer was a big yes so I hope that option will be offered in the near future!

I would suggest opening a Roth IRA online through a low cost mutual fund such as Vanguard (where I have mine) or Fidelity, etc. I can only speak to Vanguard, but I assume the others are equally simple – you just have to create an online account, choose a fund (I chose a target retirement for simplicity, but they do have many others ranging from super conservative to higher risk), and transfer your funds in. Usually if you agree to automatic recurring transfers (again what I did in order to dollar cost average) there is no minimum (or a very small minimum) required to open an account. Before you open an IRA at a bank I would be careful to check the fees. JD has spoken about this frequently and the fees can really make a difference on your long term earnings and growth. Vanguard/Fidelity, etc are low cost providers which means you get to keep more of your earnings.

Hope this helps and congrats on graduating and setting up your IRA!

I just opened up a roth ira w/ my bank so I know exactly what you’re talking about.

The deal is that you have to pick something to ‘buy’ with your money. You can get straight notes or whatever, in which case your account would not grow and would remain worth the same forever, depreciating in value for tomorrow’s dollar because of inflation.

You can buy ETFs, bonds, whatever. I personally chose to buy stocks. I’ve ‘purhcased’ $1,000 bucks worth of the QQQQ (and my next move will be to ‘purchase’ some DIA). The Q’s and DIA are low cost indices based on the nasdaw and the dow respectively, often times these are listed on the get rich slowly site as good ‘stocks’ to buy and do better than most managed portfolios whatever, look that up on here if you don’t know what to do with your money.

BUT what I can say, is that for me, when I transfer money from my checking acct to my roth ira, i automatically am buying something, i don’t even know what, it was one of the options, but it’s value doesn’t change with time. Just a way for them represent $1 as $1 worth of chicago reserves or something I don’t know. I don’t really care because I immediately log in and ‘trade’ with the money in my account and buy shares of stocks. There are some stocks you can buy w/o any trading fees, but I prefer to pay the small trading fee (usually a flat $10 bucks or something) and buy $500 worth of stuff at a time.

It’s cool because hopefully I will make some cash with my ameteur trading non-ability, but if I really need I should be able to take out some of my contribution money and bring it back to my checking to pay the mortgage if i get laid off.

I suspect there are a lot of people out there that have the same reaction. First, I will say: don’t get into the trap of hearing that an IRA is a good thing and then deciding you need one. If you don’t know why you need one, then you don’t need one. It’s your choice whether you want to invest (no pun intended) the time to understand IRAs and then make the appropriate investments or if you’d rather just stay out of it altogether (sounds like you’re doing the former, and I would too!). What is not advisable and unfortunately I suspect many people do is to not learn about IRAs and do it anyway.

Now, to answer your questions:

When I go to my bank and say “I want to open an IRA”, and they say “Ok where do you want your money to go”, I have no idea what that means.

Think of it this way. If you were to walk into your bank and hand them $10 and say you want to open an account, they would ask you what kind, right? They probably have a few flavors of both checking and savings accounts to choose from, each with their tradeoffs of balance limits, fees, interest rates, access to money, etc.

It is similar with IRAs. IRAs are just a “tax bubble” or one sort of another. When you walk money into the tax bubble, it exists under different rules, but at this point it’s still just cash. The bank is asking you what you want to actually use your cash to invest in. The typical answer is mutual funds (and I wouldn’t advise other investments for IRAs and 401ks unless you know what you’re doing). The easiest mutual funds to invest in are broadly diversified bond funds like http://www.google.com/finance?q=MUTF:VITBX and broad market index funds like: http://www.google.com/finance?q=MUTF:VTSMX

There is a lot to understanding how to take full advantage of the different tax benefits in a Roth IRA versus a Traditional IRA versus other types of accounts (this is called ‘asset location’ as opposed to ‘asset allocation’)… more than I could possibly go over in this short comment. Generally speaking, though, it’s best to put domestic stocks (eg, VTSMX) in Roth IRA and other elements of your allocation strategy (eg, bonds, real estate trusts, etc.) in your traditional IRA or 401k. If you have international stocks, generally speaking it’s best to put those in traditional IRA or 401k or, if you have one, a normal taxable account. Again, people will probably quibble with this generalizations, and that’s because they are generalizations and the recommendations are highly dependent on your particular risk tolerance, age, etc. which all are inputs into your desired asset allocation.

If I understand correctly, I can turn any “account” into an “IRA”, right? So I could turn a regular savings account into an IRA, a CD into an IRA, or an investment account into an IRA. Is that correct?

Yes, but why? The big benefit of a Roth IRA is that gains are tax free. Savings accounts and CDs have very low gains, especially now. I would stick to stocks and bonds. If you aren’t comfortable with stocks and bonds, I would hold off on opening an IRA until later in the year after you’ve learned a little more.

What’s the best way to manage an IRA? Right now, my company has pretty good 401k management options (completely passive, “target retirement” portfolios, or completely active), but are there similar options for IRAs?

Yes, likely the exact same options will be available. Target retirement accounts are okay if you truly don’t want to mess with things AND you decide that your entire investment portfolio will be in that target fund. That means your 401k is fully invested in it. It means your IRAs are all fully invested in it. It means your taxable account, if you have one, is fully invested in it. If you have other investments, you end up knocking the target fund’s intended asset allocation out of whack, which defeats the whole purpose of using a target fund. This point is why target funds have limited use… you have to have your entire portfolio invested in them, and that means that you cannot practice asset location, which is using each tax-advantaged account differently based on their different tax advantages. Using target funds, you must use them all the same (or else defeat their purpose).

Good luck.

@rma (#16) – you do not have to convert everything at once. If your account is $10k and you want to do 25% each year for 4 years that is fine, or half over 2 years.