Roth IRA Conversion Q&A: Why Is Everything So Complicated?

More than 20 million investors will be able to tap into the tax benefits of a Roth IRA for the first time under the new tax-law provision beginning on January 1. Should you convert some or all of your traditional IRA into a Roth IRA? If you decide to convert to a Roth IRA, you will be taxed on the conversion amount that hasn't already been taxed. You'll have to weigh the negatives of current taxation against the benefits of future tax-free withdrawals. With that in mind, let's take a closer look at some common questions you may have.

Who should consider a Roth IRA conversion?

Although converting a traditional IRA to a Roth IRA may not be right for all investors, it could make sense if:

  • You're able to leave the money in the account for five years or more and until you reach at least age 59.
  • You expect your tax rates to rise in the future and would rather pay taxes now.
  • You can pay the resulting taxes from a source other than the traditional IRA. This allows the full amount of the traditional IRA to grow in the Roth IRA until it's withdrawn.

What are the consequences of a conversion?

Converting your traditional IRA to a Roth IRA means that contributions and growth in the traditional IRA that haven't yet been taxed will be taxed at ordinary income-tax rates. Therefore a Roth IRA conversion could come with a hefty tax bite, depending on your situation.

Additionally, conversions can be complicated. For example, if you have more than one traditional IRA, such as an employer-sponsored SEP or SIMPLE IRA (but not including your spouse's IRAs), you'll have to add up all of them in the calculation to determine how much of the conversion amount will be taxable — even if you aren't converting all of them.

Why convert to a Roth IRA?

In exchange for paying income taxes up front, a Roth IRA offers investors a series of long-term benefits:

  • You can withdraw money tax free. This is a powerful advantage when compared with a traditional IRA, in which withdrawals, or distributions, are taxed at ordinary income-tax rates when the money is withdrawn. There are a few stipulations, however. To take tax-free distributions, you must wait at least five years after your initial contribution or latest conversion and you must be at least age 59 1/2 or disabled. You can, however, purchase your first home with Roth IRA funds tax free if you're younger than 59 1/2, so long as you've met the five-year holding period (up to the $10,000 lifetime limit).
  • There are no required minimum distributions. With a Roth IRA account, you aren't required to take yearly minimum distributions starting at age 70 1/2. That could leave more money for your beneficiaries if you don't use it yourself.
  • It can be an effective estate-planning tool. Your beneficiaries will inherit the money from your Roth IRA income-tax free. They might, however, be subject to yearly minimum distributions (your spouse may have other options).
  • A Roth IRA can provide tax diversification. Tax experts say that if you have a mix of tax-free accounts like Roth IRAs and tax-deferred accounts, such as a 401 (k) plan or traditional IRA, you'll have more of the income flexibility you may need during retirement as your tax rate rises or falls.

How can I ease the tax bite?

To help ease the tax pain, Congress has approved a special rule for conversions that are completed in 2010 only: you can treat half of the income from the conversion as received in 2011 the other half in 2012. This special rule may appeal to you if paying the taxes up front is your main concern.

Besides traditional IRAs, what other types of assets can be converted?

Any type of defined-contribution plan can be converted if you're eligible to take distributions.

Where can I get help with my decision?

In the end, your individual circumstances are the most important factors to consider. IRA conversion rules and tax calculations are complicated, and a misstep could result in unforeseen income taxes or penalties. Moreover, state tax rules may differ from federal tax rules for conversions. That's why I strongly encourage you to discuss conversion options with your tax consultant and your financial adviser before you make a decision.

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