Converting a Regular IRA to a Roth IRA?

Written by: John Landers

Many people save for their retirement by funding a traditional individual retirement account (IRA). Generally, the rules allow you to make contributions to this account and receive tax deductions. You’re only taxed on the initial investment and accumulated earnings when you withdraw the money at the 59 1/2.

Individuals can open nondeductible traditional IRAs, which entitle account holders to a partial or non-deductible contribution. However, earnings on the account accumulate on a tax-deferred basis until you withdraw money. The portion of the account that consists of nondeductible contributions gets returned to you tax-free.

Basics of Roth IRA

A Roth IRA consists of an individual retirement account that offers contributors a tax-free income in the future. The benefits of the account depend on the individual’s current tax bracket and tax bracket at retirement. Compared to traditional IRAs, individuals do not receive upfront tax deductions for Roth IRA contributions.

Since the money contributed to a Roth IRA does not have upfront tax deductions, the rules allow you to withdraw your contributions without suffering a tax penalty. However, you must pay taxes on earnings and will be penalized 10% if you withdraw earnings before the designated retirement age of 59 1/2

Starting in 2010 tax year, Congress decided to eliminate all restrictions regarding the conversion of traditional IRAs into a Roth IRA. As people approach retirement, many are trying to decide whether, converting to a Roth IRA makes good financial sense for their circumstances.

Should You Convert?

The tax code allows you to convert all or a portion of your traditional IRA to a Roth IRA regardless of your income. There are income eligibility restrictions for current year contributions based on your filing status and income.

Converting to a Roth IRA presents an attractive option if you expect your future tax rate to be higher than in your current rate. Many individuals exceed the income limits to qualify to contribute to a Roth IRA, but can convert funds as a way of getting into tax-free income during their retirement years. Taxes come due on any portion of the funds that has not been taxed

If you fall into one of the following categories, it may work to your advantage to complete a Roth conversion:

  • Your income exceeds limitations for the current tax year and you expect to move into a higher tax bracket during retirement
  • The portion of the money you convert from a traditional IRA to a Roth IRA, when added to your current year’s income, doesn’t move you into a higher tax bracket or cause some  surprising tax consequence.

Unwanted tax implications include paying higher Medicare premiums or more taxes on Social Security income because you exceed  the designated income levels of the entitlements.

Also, if you suffer losses in your existing IRA account, you can convert to a Roth IRA to pay fewer taxes and also have a greater chance for the funds to build up, tax-free. If you plan to convert to a Roth this year, you will have to pay taxes in early 2014.

Making the conversion

The tax code allows you to redesignate all or a portion of the traditional IRA to a Roth IRA. You can make this determination after making some other decisions:

  • Figure out the tax cost of making the conversion
  • Determine the long-term consequences of making the conversion
  • Establish whether you can benefit from Uncle Sam’s “one-time only” offer to spread the Roth conversion over a two year period

Generally, brokerage firms make it easy to convert from a traditional IRA to a Roth IRA. If you plan on staying with the same financial institution, there is no need to open a new account. Simply, instruct the firm to convert your traditional IRA to a Roth IRA. If you need to transfer the funds to another institution, complete a direct trustee-to-trustee transfer.


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Converting a Regular IRA to a Roth IRA?

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