Clearing the air on ROTH IRA Misperceptions

I have money tied up in a regular IRA account and now I wish I had converted this money to a Roth IRA last year. Is there any way I can still make this conversion, or was 1998 the only year for converting money to a Roth?   D.B., Indianapolis

There is a common misperception about converting regular IRA funds to the Roth IRA, that being that this was a decision that needed to be made and acted upon in 1998. The Roth IRA, a personal retirement account that can be created by any low or middle income taxpayer with earned income, provides tax-free income security for retirement. Annual contributions, which are currently limited to $2,000, are not tax deductible, but all money withdrawn from the Roth after age 59½, including all money earned in the account, is tax-free. There are no strict rules that force you to begin withdrawing money from your Roth at a certain age, nor are there restrictions about how much you can withdraw each year.

In 1998, in an effort to boost the coffers of the federal government (and you were wondering where that unexpected budget surplus came from…) the IRS provided owners of traditional IRAs with an opportunity to convert traditional IRA money to a Roth IRA and spread the tax on the conversion over a four-year period. This procedure was perceived as some sort of gift from the IRS, a one-time-only chance to spread the tax consequences of a taxable event over a four-year period.

Phooey! The calendar may no longer read 1998, but anyone can still convert money from a traditional IRA to a Roth and spread the tax over four years – or six years or 10 years, or however many years you want to take. All you have to do is convert the funds at a pace at which you want to pay the tax, keeping in mind that your income must be below $100,000 in any year in which you make a conversion.

If you have money in a traditional IRA and you want to start moving that money to a Roth IRA, and you’d like to spread the tax effects of this event evenly over the next five years, you should take one-fifth of the amount in your regular IRA and convert it this year and pay the tax. Take another portion of the regular IRA and convert it next year and pay that tax, and so on and so on for five years. If there is a year when the taxes are going to be too oppressive for you, don’t convert any funds that year, wait until the next year.

Take control of the conversion process, converting funds and paying taxes when it suits you instead of when it suits the IRS.

If the four-year spread for payment of federal and state tax on the Roth IRA conversion was used and one year has been paid in the 1998 tax year, can the taxpayer now choose to pay off the remaining three-fourths of the obligation in the 1999 tax year?

 K.E., Bloomington, IN

The IRS has never been famous for turning away money, but here’s one instance in which they seem to break with tradition. If you elected to spread your Roth conversion tax over four years and now want to get the obligation out of the way, you’re out of luck. Once you start down the path of paying the tax on the conversion over four years, the IRS wants you to stick with the plan and continue paying the rest of the tax over the remaining years.

All taxpayers who chose to spread the tax over four years should have received a friendly letter from the IRS notifying them of the tax due for 1999. This letter, which begins by telling you that the kinder, gentler IRS “thought it would be helpful to remind you” of your tax obligation, shows the amount of income that you need to include on your 1999 income tax return.

I think the logic in not letting you change your mind about how to tax the conversion is that the IRS is already mentally programmed to receive your money over four years. If you start messing with this plan, you’re going to cause no end of confusion among the ranks of IRS employees who just want to process your tax return as quickly as possible. If you pay the remaining 75% of the tax on the conversion with your 1999 tax return, the IRS will probably just send the money back. Not only that, you will still receive a friendly letter next year asking for your next installment.

My recommendation is that you take the remaining tax money that you want to give to the IRS and place it in a nice income-bearing account where it can earn some money over the next two years.