IRA to Roth: Should You and How To
Written by Bogutz and Gordon
The decision to convert your Traditional IRA to a Roth IRA is a big one. People spend weeks crunching the numbers to see if it may be beneficial for their situation. There are potential traps to avoid to ensure the IRA is properly converted. Avoiding income tax is alluring, especially when tax rates are on the rise.
With a Roth IRA, the funds going in are post-tax dollars, not pre-tax like a Traditional IRA. The benefit is that upon withdrawal of Roth funds, no income tax is imposed, so long as it is a qualified distribution. A qualified distribution is any distribution after turning 59.5, upon disability, or by beneficiaries after the participant’s death.
A qualified distribution can only be made after the holding period first has run. The holding period is five years and begins January 1 of the year you open a Roth. This means that if you open a Roth IRA on November 1, 2012, your Roth IRA holding period begins January 1, 2012. This holding period has to be satisfied only once for each individual. This means that if you have a Roth IRA that has been open for more than five years, you have already satisfied the holding period. Any subsequent Roth IRA you open has satisfied the holding period. So, it makes sense to open a Roth IRA now if possible, just in case you want to fund one in the future.
You must meet the income requirements and the contribution limits. Go here for those numbers.
Now for the conversion. You have a Traditional IRA and think, “I really want to avoid income tax on my future distributions, so I think I’ll convert.” There are two ways to fund your Roth from your Traditional IRA. The first is to directly transfer your Traditional IRA funds to a Roth. This is the safest. Second is to withdraw the funds, place them in another account, and then convert within 60 days. This is riskier because you can accidentally mix these funds with other assets. If you miss the deadline, you will not be able to convert unless you can prove a hardship. Hardship waivers are very difficult to obtain.
Once you transfer the assets, you will have to pay tax on the funds withdrawn from your Traditional IRA. After that tax is paid, all subsequent gains and income within your Roth and qualified distributions from your Roth are tax-free.
For Traditional IRA rollovers, there is a rule that you are allowed only one rollover a year. This rule does not apply for Roth conversions. You may do more than one a year.
If you are at the age that requires a minimum distribution from your Traditional IRA, you must take that distribution before conversion.
If you transfer funds to a Roth that are barred contributions, you will be penalized at a rate of 6% per year on the excess contributions by the IRS. You can correct this mistake by recharacterizing assets up to the date of October 15 if you filed your income tax return on time. If you did not file your income tax return on time, you must do so by April 15.
So, now you know the basics of how-to convert, but should you? Here are some factors to consider:
- How long until you have to withdraw the funds? The longer you plan to keep funds in the Roth IRA, the more benefit you receive.
- Do you have the funds to pay for the conversion? If you have to utilize funds in the Traditional IRA to pay the taxes, it drastically reduces or even eliminates any benefit to the conversion.
- Will the assets go up in value? Clearly you can never absolutely predict this, but the more likely that the asset value will increase, the more beneficial the conversion could be.
- What income tax bracket are you in? The lower your tax bracket, the more sense a conversion makes. If you have children in a higher tax bracket, then the benefit is even better. Upon inheritance, they will not be taxed on the income.
There are a lot of factors to consider before making a conversion from a Traditional IRA to a Roth IRA. If you are considering a conversion, see your estate planning attorney or financial advisor.
By Teresa D. Lancaster