Converting a Traditional IRA into a Roth IRA, and the Tax Consequences Thereof

Written by: Mark Cussen

Converting a traditional IRA or qualified plan to a Roth IRA is a much easier proposition now than it used to be.  Before 2010, retirement savers who wanted to convert their traditional IRAs or qualified plans to a Roth IRA faced an income ceiling of $100,000 that included the amount of the conversion.  For example, a single person earning $75,000 a year could only convert $25,000 worth of a traditional IRA or plan that year-assuming that he or she received no other forms of income.  Therefore a $100,000 conversion would have to be spread out over four years.  But this income restriction was lifted in 2010, and there is now no limit to the amount that can be converted in a single year.

Converting a traditional IRA to a Roth in a single year is not necessarily smart, just because it can be done.  The amount of taxable income that the conversion generates must still be considered, along with other factors such as tax deductions or credits that can be used to reduce or eliminate the tax on this transaction.  For example, a single taxpayer who makes $100,000 a year and wants to convert a $400,000 company retirement plan rollover would be wise to look at his tax brackets for that year and only convert a portion of the rollover account each year in order to prevent landing himself in a higher bracket.

The consequences of converting a traditional IRA to a Roth in a single year can be costly.  If the person in the prior example were to convert the entire rollover in a single year, then the tax payer would face the highest marginal tax rate on all income above $171,850.  For 2011, this person would therefore pay an additional 5 to 7% of tax on all of the income above $171,850, so if he or she had $500,000 of taxable income ($100,000 salary plus the $400,000 conversion) in one year, then this would translate into $15,000-$20,000 of taxes that might be avoided if the conversion was broken down into two or three smaller amounts done in consecutive years.  The same principle applies to smaller conversions done by lower income taxpayers.


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Converting a Traditional IRA into a Roth IRA, and...

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