Ask Me Help Desk - IRA confusion

Hello

I have made a contribution to a Traditional IRA in 2009. I claimed a deduction for this amount.
In 2010, I started contributing to employer sponsored 401k plan.
I also made an additional contribution to my traditional IRA from 2009.
When filing my taxes, my consultant advised me that I am not eligible for a traditional IRA since I was already participating in a 401K plan. He advised me to convert that account to Roth IRA.
So I converted the traditional IRA for 2009 only to Roth IRA. I did not claim any deductions on this amount for 2010.

Now, when I am filing my 2011 taxes, I am being told that my traditional IRA form 2009 is taxable and I would have to pay taxes on 50% of the amount now.
Does this really make sense? In reality, I have two accounts - one traditional and one Roth.
So why would I have to pay the tax on 2009 amount when it is technically not converted?

Quote:

Originally Posted by chat8102

When filing my taxes, my consultant advised me that I am not eligible for a traditional IRA since I was already participating in a 401K plan.

Your advisor was wrong. You can contribute to BOTH a traditional IRA and a 401(k) in the same year, no problem. Depending on your income level you may not be able to deduct your contributions, but there's no rule against contributing.

Quote:

Originally Posted by chat8102

He advised me to convert that account to Roth IRA

Converting may be a good idea, but be aware that you owe taxes on the pre-tax contributions plus earnings in the account.

Quote:

Originally Posted by chat8102

Now, when I am filing my 2011 taxes, I am being told that my traditional IRA form 2009 is taxable and I would have to pay taxes on 50% of the amount now.
Does this really make sense?

Paying taxes on the amount you converted is indeed required. I don't understand the 50% amount however, as you actually owe taxes on 100% of the IRA that was converted. Do you actually have two IRA accounts, one of which you converted and the other you didn't? In any event the conversion that you made from a traditional IRA to Roth IRA in 2011 is taxable as 2011 income. The good news is that with this conversion you'll never owe any more taxes on the Roth account, ever, regardless of how much it appreciates in the future.

*EDIT** I wonder if the 50% figure came about because the conversion of the traditional to Roth IRA actually occurred in 2010? There was a special option only for 2010 that allowed conversions to Roth accounts and the payment of taxes thus owed over two years - in 2011 and 2012. Perhaps the 50% owed in 2011 is due to a Roth conversion that actually happened in 2010? If so then taxes will be owed on 50% of the conversion in both 2011 and 2012.

Let's say you had $5000 in deductible traditional IRAs that you contributed in 2009. Then let's say in 2010, you had $5000 in non-deductible traditional IRAs (non-deductible because you didn't/couldn't deduct it). If you convert some or all of your traditional IRAs to Roth IRAs, deductible and non-deductible parts are converted together, according to the pro-rata rule. You can't just "choose" to convert the non-deductible portion.

So if you follow the above example, assuming earnings are negligible, and you had equal amounts ($5000) of deductible and non-deductible traditional IRAs, then when you converted, you would also convert equal amounts of each. So say you converted $5000 of traditional IRA to Roth IRA. Then $2500 of that would be from the deductible portion, and $2500 would be from the non-deductible portion. You only pay tax on conversions from the deductible portion plus earnings, so 50% of the conversion would be subject to tax. Your remaining traditional IRA would consist of $2500 of deductible and non-deductible each.

Did you convert in 2010 or 2011? I don't know why you are dealing with this now if it was in 2010.

--------------------------------------------------------------------------
Thank you all for your answers.
A correction and more questions

$5000 - Traditional IRA(Deductible) for year 2009
$5000 - Traditional IRA(Non-deductible) for year 2010 but the conversion to Roth was done in 2011.

I paid tax on $5000 (assuming all my non-deductible contribution converted to Roth and looks like my assumption (rather my tax consultant's) is wrong). So based on your comment, $2500 each from deductible and non-deductible were converted in year 2011(apr 12th). Does this mean I paid more tax (instead of $2500, I paid tax on $5000 for 2010 year based on your comment[You only pay tax on conversions from the deductible portion plus earnings]) OR does that mean the deductible contribution to Traditional IRA of 2009 is taxable now because some portion is converted to Roth?

So its not
$5000 (Deductible) -2009
$5000(Non-Deductible)-2010 gone to Roth

But this is what happened
$2500(Deductible)- 2009 converted to Roth in 2011
$2500(Non-deductible)-2010 converted to Roth in 2011
So I paid tax on this (above) amount and I am left to pay tax on $2500 (Non-Deductible) Traditional IRA of 2010.. which is due this year? Am I correct?

If you are paying taxes on $5K of income due to the conversion that would be because BOTH accounts converted to Roth. That's because when you convert to a Roth both accounts are essentially treated as one for purposes of figuring how much to treat as income for tax purposes. The way the taxable amount of a conversion is calculated is you take the amount converted and multiply by a factor equal to (1-(total post-tax contributions for all traditional IRAs)/(total value of all traditional IRA accounts). In your case if you converted both accounts the taxable amount would be:

$10,000 x (1-5,000/10,000) = $5,000.

If you only converted one of the accounts the tax due would be: $5,000 x (1-5,000/10,000) = $2,500.

I suggest you ask your advisor whether both accounts were converted to Roth accounts.