Do I Have to Convert My Entire Traditional IRA to a Roth IRA?
Roth IRAs were introduced in 1997, giving IRA owners the opportunity to turn their tax-deferred IRAs into tax-free IRAs. Transaction regulations prevented people with an adjusted gross income over $100,000 from participating in Roth conversions. Since January 2010, anyone can convert to a Roth regardless of income. Many questions arise about how and when you may execute a conversion. The capability to make partial Roth conversions provides tax-planning strategies to those who would otherwise face a hefty tax bill.
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IRA Characteristics
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When Congress created the IRA in 1974, the account gave workers the ability to save for retirement and lower their current taxable income by the value of their contribution. Most people believed their tax rate would drop after retirement, making taxable distributions on the account balance palatable. Traditional IRAs require owners to begin mandatory withdrawals at age 70½, allowing the IRS to recover years of deferred tax. Roth IRAs swap the contribution deduction for a tax-free withdrawal in later years. The Roth does not require owners to make any withdrawals, allowing Roth IRA owners to continue to gain non-taxable investment growth. When IRA owners convert to a Roth, they pay taxes on the entire tax-deferred value of the converted funds.
Considerations
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A conversion makes sense if you think your current tax bracket is lower than you think your future tax bracket will be. Robert Keebler, a CPA with Baker Tilly Virchow Krause LLC, tells MarketWatch that there's far more to consider. While many people convert an account based on assumed marginal tax brackets, Keebler says that technique may incur more tax on the transaction than necessary. He recommends an analysis of the conversion's tax cost using incremental tax brackets. He also believes account owners should consider a broader tax picture before making a conversion decision, including factors such as alternative minimum tax, a new Medicare Part B surcharge on high earners over age 65, estate tax and post-mortem IRA distribution options.
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Partial Conversions
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Partial Roth conversions give IRA owners time to diversify their tax risk. A Roth conversion adds to the owner's current taxable income, often pushing them into a higher tax bracket. According to Bankrate, if your traditional IRA consists only of tax-deferred contributions and investment growth, you can convert any portion of any IRA account you own, controlling your tax liability with a partial conversion. Some account owners have made non-deductible contributions to an IRA, however. Bankrate says this complicates the partial withdrawal calculations. The IRS considers the total value of all your IRA accounts. If your IRA includes after-tax contributions, every partial conversion includes a non-taxable conversion ratio. For example, perhaps you own five IRA accounts with a total balance of $100,000. One of them consists solely of after-tax contributions that equal $30,000. You cannot convert only the after-tax account. You can execute a partial conversion of the $100,000 value, but you must convert proportionally from each of your IRA accounts. Each of your partial conversions will incur income tax on 70 percent of the conversion balance.
Re-Characterization
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If you convert your IRA to a Roth, you have an opportunity to reconsider your decision. You can undo the transaction by re-characterizing the account as a traditional IRA. By transferring the balance back into a traditional IRA within the required time frame, the IRS treats it as though the conversion never occurred. You must use a trustee-to-trustee transfer, and you must complete the transfer prior to your tax-filing deadline for the year of the conversion. For example, complete the transfer by October 15, 2011 if you converted the account in 2010. The October deadline includes filing extensions.
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