How to Convert IRA Money to Roth IRA
Beginning in 2010, income limitations restricting IRA conversions to Roth IRA accounts were lifted, giving everyone the opportunity to convert traditional IRA assets into Roth IRAs. To prevent your conversion from being a costly mistake, it's important to take a step-by-step approach to ensure that you make the switch correctly. You must complete the process before December 31 of the tax year in which you are making the conversion.
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Instructions
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Making The Decision
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Compare IRA advantages. A traditional IRA -- including rollovers from a 401K or similar plan -- might allow you to pay less taxes now. Converting to a Roth IRA will increase your tax burden now, but retirement withdrawals will be tax-free. There also are no required distributions at age 70½ with a Roth, and in general, a Roth passes more easily to your heirs. In some states, traditional IRAs are protected from creditors, but Roth IRAs are not. Bottom line: the longer you have before retirement, the more sense it makes to shift traditional IRA assets to a Roth IRA.
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Consider tax ramifications. Except for any non-deductible contributions, you will owe taxes at your marginal tax rate -- but no early-withdrawal penalty -- on the IRA money you convert to a Roth. However, if you withdraw money from the IRA to pay the taxes, it is not part of the conversion and may be subject to a 10 percent early-withdrawal penalty. You get the most benefit from a conversion if you can pay the taxes from a separate, non-retirement account. In 2010, you have a one-time opportunity to defer your tax liability by splitting the money you are converting equally between 2011 and 2012. So, if you convert $30,000 to a Roth IRA in 2010, you can choose to pay taxes on $15,000 in 2011 and $15,000 in 2012. But make that decision carefully. You might be able to convert more if you make conversions and pay the taxes all three years -- 2010, 2011 and 2012. Bottom line: if you can't pay the tax without using some IRA funds, especially if it causes you to pay an early-distribution penalty, don't convert.
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Decide how much to convert. You don't have to convert your entire IRA to open a Roth. You can choose to make a partial conversion, switching only the amount you can afford in taxes or an amount that keeps you from reaching into the next higher tax bracket. If you're in the 25 percent tax bracket, and you figure you can afford $6,000 in taxes, convert only $24,000 of your IRA assets. But if half of the conversion pushes you into the 28 percent bracket, it's time to reconsider.
Making The Conversion
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Pick a custodian. If you don't already have a Roth IRA, the easiest way to make a conversion will be to open your Roth account with the same custodian you are using for your traditional IRA. You'll still have to make new account setup decisions and provide beneficiary information, but you won't have to choose new investments, and the assets can be transferred easily between accounts. If you want to pick a new custodian, contact the new provider first to get instructions on opening the account. Bottom line: If you're satisfied with your current custodian, stay put and reduce your complications.
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Select the assets to convert. The primary reason to convert to a Roth is the long-term tax advantages. If you're not converting your entire IRA, move the assets you believe have the potential for highest growth. Of course, you can't foresee every eventuality, but stocks and stock funds have historically produced higher returns than bonds and bond funds. And, if you have IRA money in CDs or other cash equivalents, convert them last. Bottom line: don't change your overall asset allocation because of a Roth conversion, but make the most of the tax advantages it presents.
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Open the account. If you're not changing custodians, you probably can open your Roth with online registration. Go to the company's website and carefully follow the instructions for opening a Roth IRA. If you switch custodians or if you plan to convert to a Roth account you own with a different company, calling for instructions is better. Be careful; each custodian has its own process. For example, if you are a Vanguard customer, you will be allowed to switch only one fund as you open the Roth online, but you can move more assets once the Roth is established. If you choose a new custodian, you'll probably need to sign some documents -- mostly establishing your identity and affirming that you are aware of what you are doing -- but the new company is likely to take care of transferring the funds from your traditional IRA administrator.
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Tips & Warnings
With no income limitations on Roth conversions, you can make non-deductible contributions to an IRA and convert them immediately to a Roth every year, effectively circumventing the income restrictions on Roth IRA contributions.
To avoid paying taxes on your non-deductible IRA contributions, you'll need to file IRS Form 8606.
If you make a conversion mistake -- or decide you don't want to convert for any reason -- don't worry. You can re-characterize the conversion, or just part of it, any time before April 15 -- or later if you file an extension.
You can't avoid taxes on a partial conversion by moving only your non-deductible contributions to a Roth. If non-deductible contributions make up 10 percent of your traditional IRA accounts, you can avoid taxes on only 10 percent of your conversion, no matter which assets you move.
