Roth IRA Conversion

If you have a traditional IRA, Roth IRA, or even 401k, you may be considering a Roth IRA conversion, or Roth IRA rollover.  Before you make the move, you need to consider the advantages and disadvantages of converting to Roth IRA.  Additionally, you will need to be aware of the Roth IRA rules governing conversions so that you can avoid some of the common mistakes that are made.

What is a Roth IRA Conversion?

At its most basic level, a Roth IRA conversion involves moving assets from a qualified, non-Roth retirement plan (such as a traditional IRA, SEP IRA, or SIMPLE IRA) into a Roth IRA.  The reverse is not possible, unless you are rolling funds over from one Roth IRA to another (Roth IRA rollover).  This would make sense as there would be no benefit in rolling a tax free vehicle such as the Roth IRA into a taxable vehicle such as the traditional IRA.

Starting in 2008, the following other types of retirement plans became eligible to be rolled over into a Roth IRA: qualified plans (such as the 401k), tax sheltered annuities (such as the 403b), and government tax advantaged plans such as 457. 

Being able to convert a 401k to Roth IRA was welcomed by the investor community as it allows individuals to avoid taking the mandatory distributions at age 70.5, which are required by the 401k.  The idea here is that even though you will owe taxes on the conversion amount, it will be beneficial in the long run, especially for those of you planning on allowing your accounts to grow for a longer period of time.  Additionally, if you believe that taxes will move higher over the long run, you can convert to Roth IRA and avoid that risk. 

Why do a Roth IRA Conversion?

You might be trying to understand if a Roth IRA conversion is the right move for your situation.  Unfortunately, there is no black or white answer here; it all boils down to your personal situation.  However, in most cases, it is advantageous to convert to Roth IRA as early as possible.

As we suggested above, converting to Roth IRA is a way of locking your tax rate in.  For example, if you are currently in the 25% tax bracket and you convert to Roth IRA, you will pay the 25% tax now in order to hedge future tax rate increases and avoid taxes at time of distribution.  The other key benefit is that there are no required minimum distributions at age 70.5 as there are with other qualified plans.  Furthermore, there are no age caps which will restrict contributions after the age of 70.5.  This feature will allow you to grow your funds for a longer period of time at a tax free rate; thereby, allowing for further compounding. 

Now, including the 2009 tax year, there is a restricted population of individuals who were able to perform a Roth IRA conversion.  As we discuss below, this will change in 2010 when all individuals, regardless of income level, will be able to convert to Roth IRA.

From an emergency perspective, converting to Roth IRA will allow individuals to make a Roth IRA withdrawal of their contributions without penalty or tax at any point in time.  This is another great benefit as compared to other retirement plans which have penalties and taxable liability.

There is a scenario in which a Roth IRA conversion could actually be a detriment.  This can happen when the tax rate a time of conversion is higher than the tax rate at your retirement age.  There are also other considerations which should be made, such as the increase in your taxable income due to the conversion.  This can have unintended consequences such as exclusion from taking tax credits for child car or college tuition.  Always consult a professional if you are not comfortable with the decision.  You can get started with a handy Roth IRA conversion calculator at MSN. 

Basic Roth IRA Conversion Rules

Converting to Roth IRA is far more involved than a simple Roth IRA rollover.  There are income guidelines, tax consequences, and rules around required minimum distributions which should be understood.  Let’s now review a few basic rules which you need to be aware of before you convert to Roth IRA:

1. When performing a Roth IRA conversion, account holders will be responsible for paying taxes on all non-deductible contributions made to their traditional IRA.

2. All inherited, non-spousal, IRAs cannot be converted into a Roth IRA.

3. For years prior to 2010, joint and single filers cannot have a modified adjusted gross income above $100,000.  Starting in 2010, the income limit restriction will be lifted, allowing anyone to convert to Roth IRA.

4. For years prior to 2010, married couples must file taxes jointly to make them eligible for a Roth IRA conversion.  For years 2010 and after, couples may file taxes separately and still take advantage of the conversion.

5. It is very important for parents with children in college to understand this rule.  For years prior to 2010, any traditional IRA funds which are deemed taxable upon converting to Roth IRA will count as additional income on your tax return.  For 2010, 50% of this taxable liability may be deferred to the 2011 and 50% to 2012. 

What does this mean to you?  Well, many of you who have children which qualify for student aid may start to exceed the income thresholds for student aid; thereby, lowering or eliminating the aid altogether.  Be very careful to understand the consequences and consult a financial planner if you are not sure. 

6. A Roth IRA conversion is similar to the rollover in that there is a 60 day period in which the amounts withdrawn from your traditional IRA must be rolled into your Roth IRA.  If this condition is not satisfied, you will be responsible for a 10% penalty plus all applicable taxes. 

7. The Roth IRA conversion basis, or dollars converted to Roth, is subject to a 5 year holding period before these amounts can be withdrawn penalty free.  Federal taxes are never charged on the distribution of your conversion basis. 

Amounts distributed in excess of the conversion basis are subject to an early withdrawal fee plus all applicable taxes unless you meet one of the three main exceptions.  Once you reach the age of 59 ½, you are no longer subject to any Roth IRA early withdrawal penalties or taxes if the conversion has occured more than 5 years ago.  Other exceptions which allow you take your funds out tax free include; qualified disabilities, purchase or renovation of first home, and distribution to beneficiary due to death. 

Basic Roth IRA Rollover Rules

While the terms conversion and rollover are used interchangeably, we will reference a Roth IRA rollover as a transfer of funds from an existing Roth IRA to another one.  The rules for a rollover are for more simple than a conversion:

1.  When performing a Roth IRA rollover, you will have 60 days to transfer the funds into a new Roth IRA account.  If you do not satisfy this time restriction and do not have an extension from the IRS, you will be responsible for paying tax on the investment gains which were withdrawn.  Remember, a Roth IRA contribution is never taxable, even if you take it out prematurely. 

2.  You may only perform 1 rollover between Roth accounts per year; these transfers are not subject to any income tax.

<< Part 1 - Roth IRA Overview
<< Part 2 - Roth IRA Contribution
Part 4 - Roth IRA Withdrawal >>
Part 5 - Distribution Ordering Rules >>
Part 6 - Recharacterization >>
Tim Ord
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