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Roth IRA Conversions

Converting from a Traditional IRA to a Roth IRA

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Updated April 15, 2014
If you have been saving for retirement in a traditional IRA, you can convert some or all of your traditional IRA funds into a Roth IRA. Beginning in the year 2010, all restrictions on converting to a Roth IRA have been removed. Prior to 2010, individuals were not allowed to convert to a Roth IRA if their income exceeded 100,000. Is converting to a Roth a good idea? That depends on several factors.

Review of IRA Basics

Here's a brief summary highlighting the different rules for IRAs:

  • Deductible Traditional IRAs: tax deduction for the savings contribution; both earnings and initial investment are taxed when withdrawn.
  • Nondeductible Traditional IRAs: partial or no deduction for the savings contribution; earnings tax-deferred until withdrawn; the portion representing your nondeductible basis is returned tax-free.
  • Roth IRAs: no deduction for the savings contribution, earnings are tax-free as long as the funds have been invested at least five years.
With Roth IRAs, an individual basically agrees to pay any tax now in exchange for tax-free treatment when the funds are withdrawn later. To achieve completely tax-free status, investors using a Roth IRA will need to defer taking any distributions from their Roth IRA until at least age 59.5 years old, the original funds have been invested for at least five years, or some other exception applies. Absent any exceptional circumstances, withdrawing money from a Roth IRA early incurs not only taxes on the earnings but also a ten percent penalty.

Prior to 2010, saving money in a Roth was limited to taxpayers who had less than $100,000 in adjusted gross income. Additionally, individuals who chose to file as married filing separately were completely prohibited from contributing to a Roth, regardless of their actual income. Such individuals had three alternatives for their savings: use a regular savings or investment account, fund a deductible IRA (if they were eligible), or fund a nondeductible traditional IRA. As we shall see, the benefits of converting to a Roth vary significantly depending on what type of investment vehicle (or "wrapper") was chosen in previous years.

Converting to a Roth

"Converting to a Roth" means, essentially, changing the tax treatment in which your retirement savings are placed. Instead of a tax-deferral available with a Traditional IRA, Roth IRAs represent post-tax contributions. Converting to a Roth means undoing the deferral by paying tax on the accumulated earnings and on any savings contributions for which the person took a deduction. This converts the funds into post-tax money.

Individuals are allowed to convert their savings from a deductible traditional IRA or from a nondeductible traditional IRA into a Roth IRA. (Both deductible and nondeductible IRAs fall under the umbrella of "traditional" IRAs. The term "traditional IRA" can mean either deductible or nondeductible IRA funds.) Beginning with the year 2010, there is no restriction (based on income or filing status) against converting to a Roth IRA.

Converting to a Roth IRA is pretty simple. All you need to do is tell your bank or other financial institution to convert some or all of your traditional IRA funds to a Roth. That's the easy part. You can keep your funds at the same financial institution. You can even keep them invested in the same investments. All you're doing is changing the type of account.

The tricky part is figuring out (1) what the tax cost of converting to a Roth will be, (2) whether converting to a Roth will save or cost you money over the long-run, (3) whether it makes sense to take advantage of the government's one-time only offer to spread the cost of a Roth conversion over two years, and (4) how much to convert. I want to make one point clear: you do not have to convert all of your traditional IRAs to a Roth. You can convert none, some, or all of your traditional IRA savings (whether deductible or nondeductible) to a Roth.

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