Roth IRA Explained

I met with my accountant this week and one of the things we discussed was retirement. I told him that I was going to try to take advantage of the 2010 Roth IRA conversion loophole by contributing to a non-deductible Traditional IRA starting this year (2008). A quick recap on the rule is that right now you have to earn under a certain amount to be eligible to convert, in 2010 that rule disappears and anyone can do the conversion. With respect to taxes, you pay income tax on the amount you convert and that amount now enters the Roth IRA world.

So, the recommendation he gave me was that if I’m going to do this, I need to keep my non-deductible Traditional IRAs segregated from my other Traditional IRAs. Right now I have a Rollover IRA at Vanguard so I will want to keep that one separate from the non-deductible one. When it comes to do the conversion, I won’t have any headaches separating the two. When I do the conversion, I pay no tax because I never deducted the contribution in the first place.

What happens if I don’t separate them? You have some minor headaches. The conversion process allows you to pick how much you want to convert. You can convert the whole thing or convert a part. When you mix the deductible and the non-deductible, you make things a little more chaotic. If you opt to convert only 50%, you can’t convert just the non-deductible part, you’ll have to convert based on the weightings. This is better explained with an example.

Let’s say your IRA has $8,000 in deductible IRA contributions and $2,000 of non-deductible IRA contributions. If you elect to convert 50% of that IRA to a Roth IRA, you’ll have to take $4,000 of the deductible contribution and $1,000 of the non-deductible. You can’t choose to take $2,000 of the non-deductible and $3,000 of the deductible IRA. If you keep them in separate accounts, you can convert them independently and thus avoid this problem.