Convert to a Roth IRA

Distributions from traditional IRAs must be rolled over into a Roth IRA within 60 days of their withdrawal.

Contributions to a Roth individual retirement account cannot be deducted for federal income tax purposes, however they offer benefits once you begin making withdrawals. The capital and any earnings they generate can be withdrawn tax-free, provided the account has been held at least five years and the owner is at least 59 years and six months old. Unlike traditional IRAs, Roth IRAs have no withdrawal or distribution mandates. Conversion consists of moving assets from one account to a newly created Roth IRA account.

Things You'll Need

• Most recent IRS Form 8606 - Nondeductible IRAs
• Investment plan for converted assets
• Tax payment plan
• Beneficiary information

Instructions

Considerations

1. Verify that your existing IRA meets conversion eligibility. According to the Internal Revenue Service, you can convert traditional IRAs, Simplified Employee Pension IRAs and Savings Incentive Match Plan for Employees IRAs to a Roth IRA as well as assets rolled over from employer-sponsored savings plans.

2. Review your tax situation with an accountant, tax expert or trusted financial adviser. Be aware that the higher your tax bracket, the more taxes you will pay upon conversion because Roth IRA contributions are taxable. In return, your Roth IRA represents a tax-free income source during retirement. Conversion could reduce your overall tax liability in the long term if the tax rate increases by the time you retire.

3. Confirm that the timing of your retirement will not cause you to breach the five-year time period required for earnings withdrawals to remain penalty-free.

Tax Factors

1. Use Form 8606 to learn the exact amount of federal tax you have to pay upon conversion. Any IRA retirement plan contribution for which you received a tax deduction results in a tax liability upon conversion to a Roth IRA.

2. Consult your tax adviser or state income tax agency to ascertain any state tax liability you might incur.

3. Determine how you will pay the taxes due. Brent Lindell, an Illinois certified financial adviser, warns that a Roth conversion only makes sound economic sense when the related taxes are paid from income, not from an IRA.

Paperwork

1. Advise the financial institution holding your account of your conversion plans.

2. Provide instructions on how to invest the Roth IRA assets and who you have designated as your beneficiaries.

3. Indicate whether you will pay the taxes due directly, or will require the institution to withhold funds from the rollover to cover the tax liability.

4. Follow up with all institutions involved to ensure that documentation and other requirements are met.

Tips & Warnings

• A conversion can be done anytime. However, to include the income in the current tax year, the conversion must be completed by December 31.

• Conversions can be completed regardless of whether an individual has taxable compensation the year of the conversion.

• A Roth IRA must be specifically designated as such when you open it.

• Savings Incentive Match Plan for Employees IRAs cannot be converted to Roth IRAs without incurring a 25 percent penalty unless two years have passed from the date of the first SIMPLE IRA contribution.

• Withdrawal requirements of qualified employer-sponsored plans must be met to convert a 403a, 403b or 457b account to a Roth IRA.

• Consider converting small amounts over time. This prevents the taxable income created by a conversion from putting you into a higher tax bracket or adjusted gross income level, both of which could limit your ability to itemize deductions.

• Contributions larger than the allowed dollar limit may be taxed at 6 percent.

• Ask your tax consultant if any state laws exist that should be considered before arranging a Roth IRA conversion.

• If you are 70 years and six months old, you must first take the required minimum distribution from your traditional IRA before doing a Roth IRA conversion.

• Using existing IRA funds to pay the taxes incurred with your Roth IRA conversion reduces your retirement nest-egg, lowers compounded investment earnings and may lead to a 10 percent penalty on the money used if you are under 59 years and six months old.

References

• Fidelity: IRA Rules and FAQs
• Internal Revenue Service: Publication 590 - Individual Retirement Arrangements (IRAs) 2011
• BankRate.com: 7 Steps to a 2010 Roth IRA Conversion
• Retirement Dictionary: Tutorials - Roth IRA Conversions
• State Farm: FAQ - Roth IRA Conversion
• CNNMoney: Help Desk - Should I Convert My Traditional IRA to a Roth?

Resources

• National Association of Estate Planners and Counselors: Roth IRA Conversion Planning in 2011 and 2012
• Fidelity Investments: Should You Convert to a Roth IRA?