Can I Convert an SEP-IRA or Simple IRA Account to a Roth IRA?
There are several types of individual retirement accounts (IRAs), all of which exist to give you a tax incentive to put money aside for retirement. If you work or have worked at a small business, your employer may have sponsored a simplified employee pension (SEP) or savings incentive match plan for employees (SIMPLE) IRA. You can roll SEP and SIMPLE IRA assets into a Roth IRA, a type of account funded solely by the owner.
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IRA Types
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To understand how a conversion works, it's important to understand how SEP and SIMPLE IRAs are different from a Roth IRA. SEP and SIMPLE IRAs are called "pre-tax" accounts because you get to deduct your contributions from your income before they are taxed. After you retire, your withdrawals are subject to income taxes. Roth IRAs are "after-tax" accounts: you can't deduct your contributions, but qualified withdrawals are tax free.
Significance
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The year you convert a SEP or SIMPLE IRA to a Roth IRA, you owe income taxes on the entire amount of the conversion. To estimate your tax bill, you can simply add your IRA assets to your projected income and look up the tax bracket into which the sum falls. The IRS has this rule to recoup tax on amounts you initially deducted from your income. Without it, you could deduct your SEP or SIMPLE IRA contributions, then roll your assets into a Roth IRA and enjoy tax-free withdrawals as well. Instead, you must choose between paying taxes now or paying them when you retire.
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Considerations
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There is another important difference between SEP and SIMPLE IRAs and Roth IRAs: SEP and SIMPLE IRAs are often funded by employers, while you alone contribute to a Roth IRA. The exception is if you established a SEP IRA for yourself to put aside self-employment income; in that case, you are free to make a Roth IRA conversion at your discretion.
It is also a good idea, and may be necessary, to roll over your employer-sponsored account into an IRA, either Roth or traditional, when you leave your job. If you are still with the employer, however, check with your plan administrator to see if you account is eligible for a rollover. You must pay a 25 percent tax penalty if you roll over a SIMPLE IRA that has been open for less than two years.
Benefits
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Rolling an employer-sponsored SEP or SIMPLE IRA into a Roth IRA gives you the flexibility to pursue your own investment strategy. In many cases, employers choose the plan administrator for SEP and SIMPLE IRA accounts, and often, the administrator does not offer employees a wide variety of investment options. Many banks, brokerage firms and mutual funds offer Roth IRAs, and you are free to choose whichever institution offers financial products that meet your needs when rolling over your accounts.
Function
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You can make a rollover in one of two ways. You can fill out paperwork with your SEP or SIMPLE IRA trustee and request a transfer to an account you set up with a new trustee. There are no penalties associated with this process. You can also withdrawal the money from a SEP or SIMPLE IRA yourself and deposit it into a Roth IRA within 60 days. The IRS requires that your SEP or SIMPLE IRA trustee withhold 20 percent of the withdrawal in this transaction. This is not a penalty, as you get the money back at tax time, but it does require you to make up 20 percent of the rollover amount out of pocket to avoid the IRS's 10 percent tax penalty on early withdrawals.
2010 Rules
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As of 2010, the federal government is making investors a special offer: convert your traditional, SEP or SIMPLE IRA to a Roth IRA and the IRS will let you spread the tax burden out over two years. For instance, if you roll over a SEP IRA worth $100,000 in 2010, you may add $50,000 to your income in 2011 and $50,000 in 2012. Or, you can pay the entire bill in 2010.
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