Hi, Gail,
Like everyone else, my investments have taken a bath this year. But, being an optimist, I’m thinking this might be an opportunity to convert some money to a Roth IRA.

The thing is, I’ve got a mix of tax-deductible and after-tax money in my IRAs (one’s a SEP and the other is a regular IRA).

If possible, I’d like to avoid paying any income tax on the money I convert. Here’s my question: can I shift just the pre-tax money to my 401(k) account and then just convert the remainder?

Thanks,
Gloria

Dear Gloria-
According to Boston attorney Natalie Choate, a nationally-recognized guru on IRAs and retirement distributions, “Yes, this works.”

For the sake of those who need a bit more explanation, the first hurdle you have to overcome is making sure your “modified” adjusted gross income in the year you do the conversion is $100,000 or less. (After 2009, this income restriction is permanently eliminated. Beginning January 1st, 2010, anyone-regardless of income- is eligible to convert pre-tax IRA assets to a Roth IRA.)

Although you have to pay income tax on the money you contribute to a Roth IRA, the benefit is that from that point on, any appreciation that your investments enjoy is tax-free.

Converting traditional (a.k.a. “regular), tax-deductible IRAs to a Roth requires that you pay income tax on any money that has so far avoided it. This includes contributions for which you took a tax-deduction as well as any tax-deferred earnings.

The tricky part is that you have to add up all of the non-Roth IRAs you own in order to calculate how much of the amount you’re converting is taxable. You can’t cherry-pick one IRA and ignore the others.

For instance, say your SEP has $50,000 in it, which includes contributions and earnings that have never been subject to income tax. Your traditional IRA holds non-deductible (after-tax) contributions of $20,000 plus pre-tax earnings of $10,000, for a total of $30,000.

Let’s assume you just want to convert $20,000 to a Roth IRA and that you would like this to come from your traditional IRA, since you’ve already paid income tax on most of the money in that account.

While you can certainly use the assets in this account to make up the $20,000, you’re required to figure the amount of income tax you’ll owe by taking all non-Roth IRAs into consideration.

Recapping the example above:
Total non-Roth IRAs: $80,000
Total after-tax contributions: $20,000
Total amount you want to convert: $20,000

First, figure out the percentage of the total that after-tax contributions represent:

$20,000 = 25% of $80,000

Next, multiply this percentage by the amount you want to convert:

25% x $20,000 = $5,000

This tells you how much of the converted amount will not be taxable. Subtract this from the converted amount to find out how much you will owe income tax on-regardless which IRA the money comes from:

$20,000 - $5,000 = $15,000

I applaud your positive thinking, Gloria. You’re definitely on the right track: if your IRAs contain nothing but money you’ve already paid income tax on, there will be zero tax due when these are converted to a Roth.

One way to do this - provided your employer’s retirement plan allows it- is to move all of the pre-tax money in your traditional and SEP IRAs into your 401(k) account.

Continuing with the example above, this would leave you with $0 in your SEP IRA and $20,000 of after-tax money in your traditional IRA.

The end result, says Choate, is that you’d “get a Roth IRA without paying any current tax.”

Keep in mind that certain conditions must be met in order to withdraw converted money from a Roth IRA without incurring a penalty. The primary one is that you’ve got to wait at least 5 years. Naturally, the longer you leave your assets in the Roth IRA, the more time they have to appreciate tax-free.

Best wishes,
G

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