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Plan Well, Retire Well

Saving and investing your money

Converting to a Roth IRA, Part I: The (New) Rules

Converting from a traditional to a Roth IRA is a hot topic this year, for a couple of reasons. Two significant barriers - income and filing status - have been removed. And, tax rates will be changing in 2011, making 2010 tax rates look like a good deal. Over the next few days, I'm going to try to pull together all the pieces of information you might need to evaluate whether a Roth conversion makes sense for you. Today, we're going to start by learning the rules about conversions. Hold onto your hat, because some of these are more complicated than the news media has led you to believe.

Rules for Roth Conversions:

Beginning this year (2010), anyone can convert money from a traditional IRA, SEP IRA, or a SIMPLE IRA to a Roth IRA.

  • Restrictions based on income or tax filing status have been removed.
  • You can also convert money from an employer plan [401(k), 403(b), 457, and profit sharing plans] to a Roth IRA.
  • Special rule for SIMPLE plans: In the first two years of participation in a SIMPLE plan, rollover to an account other than another SIMPLE plan is prohibited.

You will owe tax on the amount converted, at your marginal tax rate.

In 2010, you can choose whether to recognize the income and pay the tax in 2010, or whether to spread the income between your 2011 and 2012 tax years and pay the tax at the rates in effect in those years.

Unless new legislation is passed, tax rates will increase in 2011. The laws which reduced tax rates to their current level will expire, and most tax brackets will go up 3% or more.

If you have made non-deductible contributions to an IRA, those amounts will be converted tax-free. However, you cannot convert just the non-deductible contributions. You must add together the balances in all of your traditional IRA accounts (including SEP and SIMPLE IRAs), and calculate the proportion of that total that is from nondeductible contributions.

You can do a conversion at any age. Taxes will apply, but there are no early distribution penalties if you are not yet age 59 ½. If you have a required minimum distribution for the year of the conversion, you must still take that distribution: it cannot be converted.

Conversions can be un-done, or recharacterized, as late as the due date (including extensions) for the tax return for the year in which you did the conversion. So you could have until Oct. 15, 2011 to change your mind about a conversion done in 2010 and put the money back into a Traditional IRA.

Converted amounts on which you pay tax at conversion must be held in the Roth account for five years before distribution. Otherwise, those amounts may be subject to a 10% early distribution penalty. There are exceptions to the 10% penalty. Exceptions include being aged 59�½ or older, disabled, a beneficiary rather than the original account owner, and several others. You can find the details about exceptions to the early distribution penalty in Taking Distributions from Tax-Deferred Retirement Plans.

You may need to make estimated tax payments or increase your withholding for the years in which you will recognize the income from the conversion, to avoid penalties for underpaying your taxes.

There are no required minimum distributions from a Roth IRA for the original owner, or for a beneficiary spouse who re-titles the account in his/her own name. There are required minimum distributions for beneficiaries other than a spouse, and for a spouse who leaves the account in the name of the deceased.

The conversion can be done by

  • trustee-to-trustee transfer,
  • converting with the same trustee,
  • or a rollover, meaning that you receive the funds and are responsible for depositing them in the new account within 60 days. With a rollover, the original custodian will be required to withhold 20% for taxes. If you want to convert the full balance of the traditional IRA, you will have to make up the difference with other funds.

Now that we've got the rules under our belts, we'll next tackle how to go about deciding whether converting is the right thing for you. So make sure to watch for my next post, which I plan to have up in a couple of days.

If you have questions about Roth conversions that you'd like to have answered, please click on my name below and send me an email. I'll try to address those in a future post.

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