How Can an Individual Convert a Traditional IRA to a Roth IRA?
Converting a traditional IRA into a Roth IRA has been made easier. As of 2010, there are no income limits in converting a traditional IRA into a Roth IRA. The income limit was $100,000 per year in adjusted gross income and you couldn't convert if you were a married spouse filing independently.
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How to Convert
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Converting is as simple as taking a distribution from your traditional IRA and depositing it in the account. According to the IRS, "You can withdraw all or part of the assets from a traditional IRA and reinvest them (within 60 days) in a Roth IRA." The IRS calls this a contribution conversion and if done within the 60-day time frame, one can avoid a 10 percent penalty.
Tax Liability
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You will have to pay income taxes from your traditional IRA at your current rate. If you don't have the resources available to pay the income taxes, you can take them from the traditional IRA. However, there will also be a 10 percent penalty for the early distribution.
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Is it Worth It?
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It will take planning to determine whether to convert the entire traditional IRA to a Roth. In 2010 and 2011, your tax liability can be split over the next two years, making 2010 an opportunity to lessen the tax hit. However, if you are paying taxes from the traditional IRA plus the 10 percent penalty, there are factors that should be examined before moving all the money.
Taxes
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The first thing is to determine whether or not you are going to move to a higher tax bracket in the future. You are going to be taxed at your current income bracket when you remove the money from the traditional IRA. If you move up to a higher bracket in the future or if taxes go up, it may be better to make the move sooner to a Roth to shelter yourself from taxes.
Savings
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If you are going to remain in the same bracket or move down, you may be paying money in taxes that could earn greater returns if the money stayed in the traditional IRA. For example, if you are paying taxes from your traditional IRA plus the 10 percent tax penalty, you should determine whether the after-tax earnings of the traditional IRA are greater or lower than the expected returns from the Roth IRA. If the Roth IRA fails to match the traditional IRA, then you may choose not to convert or convert less.
Other Factors
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There are other nontax factors to examine. Estate planning, its size and other future plans must be considered. IRAs often have provisions for early distributions that don't suffer tax consequences, such as for housing or education and training.
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