Converting to a Roth

Converting to a Roth

Frequently Asked Questions, Answered 

 

Finding information on Roth IRAs is easy, as it is a popular topic these days. However, deciding whether or not to convert is a bit trickier. The following are some frequently asked questions for your consideration. Remember, your financial advisor is the best resource to insight as to how this new opportunity impacts your personal financial situation.

 

What Plans Are Eligible for Roth IRA Conversion?

 

  • Traditional IRAs
  • SEP IRAs
  • SIMPLE IRAs

 

Education IRAs and IRAs that were inherited are not eligible. 401(k), profit sharing, 403(b) and 457 plans may be eligible in limited circumstances if the plan document allows for in service distributions.

 

What Changes Have Been Made to Roth IRA Eligibility?
 

Before 2010, only individuals with modified adjusted gross in­comes (AGI) of $100,000 or less could convert amounts in their traditional IRA to a Roth IRA. Moreover, married taxpayers filing separate returns have also been prohibited from converting their traditional IRA to a Roth IRA as well.

 

Beginning in 2010, the $100,000 AGI limit on conversions of tra­ditional IRAs to Roth IRAs is eliminated completely. This special treatment gives everyone regardless of his or her income level the opportunity to convert a traditional IRA to a Roth IRA. Addi­tionally, filing status restrictions are also lifted, allowing married taxpayers filing a separate return to convert a traditional IRA to a Roth IRA.

 

What Is a Qualified Distribution?
 

To be qualified, a distribution from a Roth IRA must be made after the contributor reaches age 59 ˝ or be made on account of a lim­ited set of special reasons. In addition, there is a five-year hold­ing period for contributions – if they are distributed out before five years is up, they will not be qualified distributions. Note that converting to a Roth starts a new five-year holding period on the assets deemed contributed by that conversion.

 

What Happens When You Convert a Traditional IRA to a Roth IRA?
 

An IRA conversion is treated as a taxable distribution, which is taxed as ordinary income at your marginal tax rate. This, in ef­fect, accelerates the taxable income that you would eventually have had to pay on distributions from a traditional IRA once you retire. The trade-off is that paying the tax now means that any fu­ture appreciation in the value of your Roth account would not be taxed. That is often a significant tax advantage. You should also note that unlike a withdrawal from an IRA, a conversion doesn’t trigger the 10 percent early withdrawal penalty for early or non­qualified distributions.

 

Although conversion to a Roth IRA triggers immediate taxable income, Congress provided a special incentive in 2010 to jump-start Roth conversions. In 2010 only, individuals are deemed to recognize the conversion income half in 2011 and 2012 at the rates in effect for the applicable year. This can be elected out of if it makes sense to recognize the conversion income all in 2010.

 

What Else Should I Consider in This Decision?
 

For some taxpayers, their tax rate may rise after 2010 even if their income does not. The Bush tax cuts are set to expire and in­come tax rates will rise automatically in 2011 absent some action by Congress. Numerous proposals are out there dealing with this change in rates. President Obama has proposed freezing the tax cuts on all but the highest two tiers of income tax brackets. This might be a reason to consider electing out of the two-year defer­ral treatment and recognizing all the conversion income in 2010.

 

The tax-free nature of qualified Roth IRA distributions may pre­vent individuals from being taxed in a higher tax bracket than would otherwise apply if he or she were withdrawing taxable distributions from a traditional IRA. Moreover, these distribu­tions – unlike those from traditional IRAs – do not affect the calculation of tax owed on Social Security payments and do not affect AGI-based deductions.