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Traditional IRAs: tax deduction for the savings contribution; both earnings and initial investment are taxed when withdrawn.
- Nondeductible Traditional IRAs: partial or no deduction for the savings contribution; earnings tax-deferred until withdrawn; the portion representing your nondeductible basis is returned tax-free.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.
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.
