You may have heard that 2010 is the year to convert to a Roth IRA. The $100,000 AGI limit is coming off, and you will have the option to pay the tax over a two-year period. So, if you convert $50,000 in 2010, you can pay the tax in 2010 or spread it over the next two years – 2011 and 2012.

We practitioners knew that this moment was coming. The tax law changed back in 2005 (Tax Increase Prevention and Reconciliation Act of 2005). Many of us thought that we saw a way to fund a Roth, even if the taxpayer was over the annual Roth income limits for contributions. How? Well, by funding a nondeductible IRA for 2006, 2007… well, you get the idea. We would convert it over to a Roth in 2010. The only part that would be taxed was the appreciation, and that wasn’t so bad.

This idea won’t work. In fact, there is a nasty trap.

Let’s walk through an example.

Charlie has contributed $12,000 to a nondeductible IRA over the years. It is now worth $19,000. He has left previous employers and rolled his 401(k) into an IRA. That IRA is worth $82,000. In 2010 he converts the $19,000 IRA to a Roth.

One would think that his income would be $19,000 - $12,000 = $7,000

One would be wrong.

The IRS says that you have to figure out his nondeductible as a percentage, not as a dollar amount. The denominator is the sum of all his IRAs, not just his nondeductible IRA. For Charlie, this math would be $12,000 divided by ($19,000 + 82,000) which equals 11.9%. When he converts $19,000, the IRS says his basis is $19,000 times 11.9% which equals $2,257. Charlie’s income upon the Roth conversion will be $19,000 minus 2,257 which equals $16,743. There’s a surprise.

Sorry Charlie.