Advice IQ: Should you convert to a Roth IRA?
Turning your individual retirement account into a Roth IRA is not a totally black-and-white decision. Understand the rules first, especially relevant tax laws.
Traditional IRAs are largely based on income tax deferral, which means you get a tax break on your contributions in the current year. In retirement, your withdrawals incur income tax.
With a Roth IRA, you pay no income tax on plan contributions; your investment earnings incur no income taxes, either. And great news on the back end: When you begin taking withdrawals from the plan, you again pay no income tax.
You do have to be at least age 59½ when you begin taking withdrawals from the Roth and participated in the plan for at least five years.
Roth IRAs hold another advantage, one that becomes increasingly important as you age through retirement. Virtually every other tax-sheltered plan requires you to begin taking required minimum distributions (RMDs) no later than 70½. Roth IRAs stand alone among plans as they do not require RMDs.
This plus allows you to continue accumulating money in your Roth during the time when you must draw down the balances of your other retirement accounts – reducing the risk that you'll outlive your money.
Rules for converting. Though your Roth IRA contributions are limited to $5,500 a year ($6,500 if you're 50 or older), there are no dollar limits regarding conversions. You can do a conversion one of three ways:
• 60-day rollover. Here, when you shift the funds from your traditional IRA into a Roth IRA, you first park the money as an interim step in your bank account. You must move the money into the Roth within 60 days of the distribution from your traditional IRA. If you don't, the amount of the distribution (less non-deductible contributions) incurs taxes in the year received, the conversion doesn't take place and the Internal Revenue Service socks you with a 10% early withdrawal penalty.
• Trustee-to-trustee. The easiest way to work the transfer, this method also virtually eliminates possibility that funds from your traditional IRA will be taxed. You tell the trustee of your traditional IRA – usually a large asset management company like Fidelity or Vanguard – to direct the money to the trustee of your Roth IRA.
• Same trustee transfer. The money stays in the same institution. You set up a Roth IRA with the trustee who holds your traditional IRA and direct it to move the money into your Roth account.
No matter how you accomplish the transfer, funds coming out of your traditional IRA are subject to regular income tax upon withdrawal later on, like when you retire. Any non-deductible contributions you made to your traditional IRA will not be taxed, though, since they never had the benefit of tax deferral. If the conversion is done properly, you also won't get hit with the 10% penalty.
If you began taking substantially equal periodic payments from your traditional IRA – a parceled withdrawal system based on your life expectancy – you can convert those amounts to your Roth IRA as the payments arrive. The payments are taxable but again you avoid the 10% early withdrawal penalty. Note: You cannot convert RMDs to a Roth IRA.
Portion rules. Some mistakenly believe that rolling over only the portion of the IRAs made with non-deductible contributions side slips the income tax liability of a conversion. For example, if you have $200,000 in an IRA account – say, $100,000 in investment earnings, $60,000 in deductible contributions and $40,000 in non-deductible contributions – you may think you can roll over the $40,000 to avoid income taxes.
Wrong: The IRS Roth conversion pro rata rule holds that the tax-exempt portion of your rollover contribution must constitute only a pro rata share of the total rollover. Since $40,000 of your total IRA balance comes from non-deductible contributions, you qualify for tax relief on only 20% ($40,000 in non-deductible contributions divided by the $200,000 total balance) of the amount of any rollover you convert to a Roth IRA.
(On my website, I offer fuller examples of conversion from a traditional IRA to a Roth IRA.)
Other accounts. You can convert different tax-deferred retirement plans to a Roth IRA: for entrepreneurs and the self-employed, a savings incentive match plan for employees (SIMPLE) IRA (after two years) or asimplified employee pension (SEP) IRA; a federal government 457(b) plan; a 403(b) for school and tax-exempt organization employees; and a designated Roth account within a 401(k), 403(b) or 457(b).
(Except for the case of a designated Roth account, all income is taxable in the year of conversion.)
With a Roth conversion, you do pay taxes on the amount converted in the current year and, depending on your tax bracket and how much you convert, the tax bite can hurt. But you exchange a current tax obligation for tax-free distributions in retirement: That's a powerful advantage if you think income taxes will go higher in the future.
Jeff Rose, CFP, is the founder ofAlliance Wealth Managementin Carbondale, Ill., and is a member of theAdviceIQ Financial Advisors Network, which is a USA TODAY content partner offering financial news and commentary. Its content is produced independently of USA TODAY.