Converting from a Traditional IRA to a Roth IRA
You might find it odd to consider moving money you have put away in a tax-deferred traditional IRA to a Roth IRA, which uses after-tax dollars. Part of what makes this choice painful to execute is that you will be required to pay income taxes on the monies that had been sheltered from a tax obligation while in the IRA. Most experts agree, however, that if you qualify for a Roth, you will make out better in the long run.
If you are married and you and your spouse file your taxes separately, it will not be possible for you to convert to a Roth IRA. If, however, you and your spouse have lived apart for the entire year and you file separately, you may be eligible if all other requirements are met. The chief measure of eligibility is income. You, or you and your spouse combined, cannot exceed $100,000 in modified adjusted gross income. You may not know for sure if you meet this requirement until your taxes are prepared.
It is possible to hold both traditional IRAs and Roth IRAs. When converting to a Roth, you can elect to convert all of these assets or only a portion. A conversion has to be completed by December 31 of a tax year, even though contributions for that year can be made until April 15 of the following year.
What Can Be Rolled Over to a Roth IRA
Company plans are not allowed to be rolled over to a Roth. If you have any or all of traditional, SEP, or another Roth IRA, these can be rolled over to a Roth IRA. SIMPLE IRAs also can be rolled over to a Roth IRA if you have participated in the plan a minimum of two years. Prior to that, it is possible to roll one SIMPLE IRA to another SIMPLE IRA.
You can roll over to a Roth IRA any year your income falls below the $100,000 ceiling. If you have earnings above that in any given year that would lock you out of a Roth IRA, you may want to use a traditional IRA or other pension plan available to you. In years you are under the income threshold you can continue to contribute to your Roth IRA.
You must roll over your money to the new IRA in the same form as it was in the old IRA. If you had it in bonds, then bonds are what you roll. If there is property in the IRA, the exact property, or cash proceeds from the property, must be rolled. You are not permitted to use cash from an IRA to purchase property and then roll that property over.
If you inherit an IRA from your spouse, it is treated as though it was yours and you are permitted to roll it over if you meet all other requirements. But if great-uncle George kindly named you as beneficiary of his IRA, regrettably it would not be eligible for a rollover to a Roth IRA.
Partial Rollover and Nondeductible Contributions
If you have added nondeductible contributions to your IRA because you were beyond the income limits established for pre-tax deductions, you have an added reason to do a rollover. Those dollars are tax free, because they came from your after-tax earnings in the past. Remember that earnings on these after-tax dollars held in your IRA will be subject to tax when you begin to take distributions. By moving them to a Roth IRA, both the after-tax contributed dollars and their earnings are in a tax-free zone.
The one catch to be careful of is this: If you do only a partial rollover, you will not be allowed to designate only the after-tax contribution dollars. For example, if you have an IRA that at present comprises 70 percent pretax-dollar contributions and 30 percent after-tax-dollar contributions, you would need to follow that ratio for any portion of the IRA rolled over.
You may be asking yourself, “Why not always do a full conversion?” Generally speaking, a full conversion is the more desirable way to go. The circumstances you'd want to avoid are:
Creating enough additional income to push you into a higher tax bracket
Not having enough cash on hand in order to make the tax payment necessary
If you wind up using some of the proceeds from the rollover and you are under 59½, you may be facing the 10 percent penalty for early withdrawal on top of the income taxes due.
Advantages of the Roth IRA
If you have plenty of work years ahead, you will definitely wind up with a bigger nest egg using Roth after-tax contributions compared dollar for dollar to using tax-deferred contributions. The main difference is that earnings in a traditional IRA will be taxed while earnings in a Roth IRA will not. Think about it. A pot of $50,000 in earnings in the traditional IRA may be taxed at 15 percent when you begin to take distributions, making it effectively $42,500 compared to the intact $50,000 in a comparable Roth IRA.
Unlike other IRAs, you never have to take your money out of a Roth IRA — at any age, enabling you to leave more money to your heirs. And speaking of heirs, yours will pay tax on money they withdraw from an inherited traditional IRA, but not on monies from your Roth IRA, making it more valuable than a traditional IRA.
A nonfinancial benefit for using a Roth IRA is the flexibility it affords you in withdrawing money before age 59½ without incurring that annoying 10 percent penalty. Just bear in mind that you will have to have held the account for at least five years — no matter at what age you open it — before you can access the funds.
When weighing the benefits of converting from a traditional to a Roth, look at how far you are from retirement. If you expect to continue working at least another ten years, it is probably worth paying the taxes on the converted funds when you factor the compounded earnings that will not be taxed later. If you are closer to ending your earning years and will see a significant drop in your income bracket, it would make more sense to stay put with the IRA and pay the lower taxes later.
