"That would be like trying to separate the cream from your coffee after pouring it in-it just can't be done," he said. "Instead, when a partial conversion of IRA assets is done, a pro-rated amount of after-tax money, or basis, is included with each dollar converted."
The formula for calculating this amount is this: Total basis in all IRAs divided by the total value of all IRAs times the amount converted.
7. Rolling to an IRA mid-year
If you plan to roll your 401(k) into an IRA in the same year that you do the conversion, be sure to avoid this trap. "When an IRA is converted, only IRA assets are taken into consideration for the pro-rata rule," said Slott. "Plan assets have no effect."
For example, consider the case where someone has an IRA worth $50,000, of which $25,000 is non-deductible contributions and $25,000 is earnings, said Slott. This hypothetical person also has a 401(k) worth $450,000, all of which is pre-tax. If the person converts the entire IRA, he will owe tax only on $25,000 since the plan assets are excluded from the pro-rata formula.
8. RMDs must be taken first
Just when you thought you could get rid of required minimum distributions (RMDs) forever, this trap comes along. Yes, many IRA owners were waiting, breath bated, for 2010 so they could convert and stop taking those tax-causing RMDs. Well, 2010 has arrived, but those IRA owners have to be careful not to act too quickly.
"In their haste to convert, some IRA owners might convert their entire account balance not knowing that their RMDs cannot be converted to a Roth IRA," Slott said.
"Individuals who are 70 1/2 or older in 2010 must first take their 2010 RMDs if they plan to convert all their IRAs to Roth IRAs. The first dollars withdrawn from the IRA are deemed to be the RMD until that amount is satisfied. Once the RMD is withdrawn, then the remaining IRA balance can be converted," he said.
9. Some funds are not eligible for conversion or contribution