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A Unique Tax Strategy for a Roth IRA Conversion


This year, savers can convert traditional IRAs to Roth IRAs no matter how much they earn -– though high-income healthcare professionals don't seem in a big rush to do it. Now, some financial advisors are suggesting a unique Roth conversion tactic that may be worth a look.

In 2010, you can turn your traditional IRA into a Roth IRA, no matter how much you earn. But with less than nine months to go for higher-income savers to convert to Roths to benefit from the one-time opportunity, doctors and other high-earning healthcare professionals don’t seem to be any big rush to do it.

A recent study by Fidelity Investments of investors showed that only 14% of investors surveyed were considering a Roth conversion, and more than half (56%) said they definitely won’t convert to Roths.

Many financial advisors believe the lack of enthusiasm has to do with investor confusion over the complexity of the process, as well as fears about the taxes that would be owed on any amount converted. Now, some financial advisors are suggesting a new Roth conversion strategy that may help ease those concerns.

With traditional IRAs, investors typically get an immediate tax deduction on their contributions. Earnings on IRA savings grow tax-deferred until retirement, when withdrawals are taxed at ordinary income tax rates. Roth IRAs, on the other hand, are funded with after-tax dollars. But earnings on Roth contributions generally grow tax-free, as long as account holders follow the rules for withdrawal. (Learn more about Roth IRA rules and eligibility guidelines here.)

When investors convert from IRAs to Roths, they must pay the taxes due on their initial contributions as well as the earnings. How much they’ll pay depends on several factors, including total household income, and federal, state and local tax rates. To help ease the tax bite, this year the IRS is allowing savers to spread out tax payments owed over 2010, 2011 and 2012.

Financial advisors are offering up a number of strategies to make the tax bill as painless as possible. The latest tactic suggests converting to a Roth using savings from an IRA that’s funded with non-deductible contributions. Since the money in the IRA has already been taxed, investors who convert to a Roth would owe taxes only on any earnings accrued. For example, some financial gurus are suggesting that upper-income taxpayers open non-deductible IRAs this year with the maximum contribution allowed ($5,000 if you’re under age 50; $6,000 if you’re older) and then convert immediately to a Roth.

But there’s one problem with this tactic: If account holders have more than one IRA -- one funded with tax-deductible contributions, one funded with after-tax contributions -- the IRS treats them all as one large retirement account when figuring out the tax owed on a Roth conversion. If your other IRA is funded with pre-tax contributions, you could end up owing tax even though you funded your Roth with funds from the after-tax IRA.

For example, if a radiologist had a $6,000 IRA funded with pre-tax contributions, the IRS would lump it in for the sake of conversion with the $6,000 after-tax IRA. That adds up to one large IRA worth $12,000, of which half is considered pre-tax contributions. If the radiologist took $6,000 out of the after-tax IRA to convert to a Roth, the IRS would figure that he or she owed tax on half those funds.

Confused? You’re not alone. If you think you may benefit from converting your IRA to a Roth, be sure to consult your financial planner or tax advisor before the time on this one-time opportunity runs out.

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Victor J. Dzau, MD, gives expert advice
Victor J. Dzau, MD, gives expert advice