Converting IRAs to Roth IRAs
Roth IRAs have some features that make them more attractive
than distributions from the account are exempt from taxes and penalties. (On the
other hand, your contributions to a Roth IRA are funded with after-tax dollars.)
Your entire Roth IRA balance may also be distributed tax- and penalty-free if
you have held the account for at least five years and are disabled, are taking
out up to $10,000 to buy a first home, or payments are being made to a
beneficiary or your estate after your death.
A second advantage of Roth IRAs is that they do not require minimum
distributions (RMDs). As a result, you have more flexibility in managing your
estate. Instead of taking distributions that you may not need but are required
to take, you can leave the money to your beneficiaries.
Tax laws let you convert the assets in a regular IRA to a Roth IRA in a process
called a Roth conversion. To complete a Roth conversion, use a Roth rollover or
Converting the assets in a regular IRA to a Roth IRA is a trade-off. On one
hand, you owe taxes in the year that you convert. This is because you are moving
assets from a tax-deferred account funded with tax-deductible contributions to a
retirement account funded with after-tax contributions.
For example, assume you convert a regular IRA with $100,000 in assets to a Roth
account. If you're in the 25% income tax bracket, you would owe $25,000 in
income taxes in the year of the conversion.
A major consideration in choosing to convert to a Roth IRA is your expected
future tax bracket. When you retire, your income is likely to drop. This may
push you into a lower tax bracket. As a result, your distributions from a
retirement account are less heavily taxed. While taxation of distributions is a
moot point for qualified Roth IRAs, taxation affects the value of distributions
from regular IRAs.
The basic rule of thumb is if you expect to be in the same (or higher) tax
bracket when you become eligible for distributions, a Roth IRA has extra appeal.
Conversely, if you expect to be in a lower tax bracket, a regular IRA has extra
Roth conversions are not as attractive as they were in 1998, the first full year
that Roth IRAs were in existence. At that time, there was a one-time rule that
year allowed investors to spread out the tax impact of conversions over four
A Roth conversion may make sense if the account grows enough in the future to
make up for the bigger tax bill you face when you convert. You may wish to
remember the following on Roth conversions:
Income limit and tax filing status. You are allowed to convert a regular IRA to
a Roth IRA if your modified adjusted gross income (MAGI) does not exceed
$100,000. You also cannot convert if you are married and you and your spouse are
filing separate tax returns.
Timing to avoid penalty. You can avoid an early-withdrawal penalty equal to 10%
of the conversion amount if you complete a Roth rollover within 60 days. If you
are under 59 1/2 years old and keep any of the withdrawal or miss the 60-day
rollover period, you should plan on paying the penalty.
Receiving RMDs on a regular IRA. If you are already receiving RMDs from a
regular IRA, you cannot convert the RMD amount to a Roth IRA. You can convert
any portion that is not part of the RMD.
The above information is educational and should not be interpreted as financial
advice. For advice that is specific to your circumstances, you should consult a
financial or tax adviser.