Converting a Traditional IRAto a Roth IRA

The case or converting, and how to do it

Investor Education

While Roth IRAs currently comprise only a small fractionof the total $4 trillion IRA market, they are poised to growas a result of recent tax law changes. As investors becomemore concerned about the impact of taxes in retirement,Roth IRAs present a tax-free income alternative. Unlikemost retirement accounts, Roth IRAs feature withdrawalsthat are free from federal income taxes, making them anattractive vehicle for a wide range of retirement savers.

Roth conversions available to everyone

When the Roth was rst introduced in 1998, tax lersearning more than $100,000 were ineligible to converttheir tax-deferred retirement accounts to Roth IRAs.But beginning in 2010, that income cap was eliminated,making Roth IRAs available to all investors. Converting toa Roth IRA is a taxable event — federal income taxes aredue on the value of pretax contributions and any earnings.

 Income limits were based on modied adjusted gross income (MAGI).

All tax-deferred IRAs, including Traditional, Rollover,SIMPLE, SEP, and SAR-SEP IRAs, are eligible for a RothIRA conversion. Most employer-sponsored retirementplans, such as 401(k)s and 403(b)s, are also eligible, aslong as there is an accompanying “triggering event,”such as a job change, retirement, or the account holderreaches age 59½.

 SIMPLE IRAs may not be converted until two years from the date theaccount owner rst began participating in the plan.

The case or converting

The tax treatment of withdrawals is the biggest dierencebetween Roth IRAs and other retirement savings vehi-cles. For that reason, investors considering convertingto a Roth IRA will often ask themselves whether theirtax liabilities are likely to be higher now or in retirement.Making that kind of prediction is a dicult task, and onethat can often be based on awed assumptions. Forexample, many individuals are nding that they wantto work at least part-time during their retirement yearsfor a variety of reasons. That income — combined withincome from Social Security, any annuities, and requiredminimum distributions from Traditional IRAs — may putyou in a higher tax bracket than you anticipate. Moreover,if tax rates increase between now and the time you retire,earning less income would not necessarily mean you’llowe less in income taxes.

YOUR TAXES MAY GO DOWN IF:

• You expect to stop working (or only work part-time) and,therefore, would earn less and be in a lower tax bracket• You plan to move to a state that has lower, or no, stateincome taxes• You plan on moving to a larger home, increasing the amount ofdeductible interest you can claim• You expect to have signicant deductible health-care expenses

YOUR TAXES MAY GO UP IF:

• You plan to pay o your mortgage or move to a smaller home,therefore decreasing the amount of deductible interest youcan claim• You are claiming dependents now that you won’t be able toclaim in retirement• You expect to receive signicant income from large lump-sumretirement plan payments, IRAs, or annuities• You plan to liquidate taxable investment savings or other assets• You plan to move to a state with higher income taxes

For investors who can aord the taxes due on a conver-sion, Roth IRAs oer a number of compelling benets:

#1: Tax diversication

Most investors understand the benets of diversifyingtheir portfolios by spreading their assets among a varietyof investments. But not all investors consider how todiversify their tax liability by spreading assets amongtaxable, tax-deferred, and tax-free accounts. Often,investors hold a disproportionate percentage of theirassets in tax-deferred accounts, such as Traditional IRAsand 401(k)s, with little or no assets in tax-free retirementvehicles, like a Roth IRA.

#2: No required minimum distributions (RMDs)

The fact that Roth IRAs oer tax-free withdrawals is justone appealing feature. Roth IRAs also are more ex-ible savings vehicles, with no RMDs starting at age 70½.While widespread double-digit market declines such asthose of 2008 are uncommon, they’re not unheard of,and mandatory taxable withdrawals from one’s retire-ment account only compounds the problem of marketvolatility. The ability to choose when and how much towithdraw from your retirement account can be a valu-able feature, and it is one Traditional IRAs don’t oer.

#3: Leave a tax-free legacy to the next generation

Since there are no distributions required for the accountowner or spousal beneciary, more assets may be left inthe Roth account for potential tax-free growth. For thisreason, many auent individuals looking to maximizethe legacy they leave their beneciaries may nd RothIRAs attractive. Non-spouse beneciaries are required totake minimum distributions from the Roth IRA; however,these proceeds are free of income taxes as long as theaccount has been established for at least ve years.

Calculating taxes due on a conversion

In many cases, the Traditional IRA or retirement plan beingconverted will consist of pretax contributions and earnings.In such cases, the entire amount converted — contribu-tions plus earnings — will be taxable as ordinary income.In some cases, an investor may hold “after-tax” funds inhis or her IRA, such as in a non-deductible IRA. Since thecontributions were previously taxed, only subsequentearnings would be taxable on a conversion to a Roth IRA.

EXAMPLE 1ASSUMPTIONS

• Investor owns a non-deductible IRA, valued at $20,000• The non-deductible IRA includes $10,000 in after-taxcontributions and $10,000 in earnings• The investor does not own any other IRAs (including a SEP IRAor a SIMPLE IRA)• The investor would like to convert the $20,000 non-deductibleIRA to a Roth IRA

RESULTS

• $10,000 in after-tax contributions are not taxed• $10,000 in earnings are taxable at ordinary income tax ratesat the point of conversion

Calculating taxes or investorswith multiple IRAs

However, if the investor owns a non-deductible IRA andholds assets in other IRAs, guring the taxes due uponconverting to a Roth IRA becomes more complex. Forthe purpose of calculating the taxes at conversion, all IRAaccounts must be considered in aggregate. To gure thetaxes due, you need to determine which IRA assets havebeen previously taxed. Here’s how it works:

EXAMPLE 2ASSUMPTIONS

• Investor wants to convert an IRA consisting of $10,000 innon-deductible contributions and $10,000 in earnings($20,000 total value)• Investor also owns a Rollover IRA valued at $80,000, whichhe does not wish to convert

$10,000non-deductibleIRA earnings$10,000non-deductibleIRA contributions$80,000Rollover IRA10%of total valuehas alreadybeen taxedNo taxes havebeen paid onremaining 90%

RESULTS

• 10% of the investor’s total IRA balance ($10,000) has alreadybeen taxed; therefore, 90% of the balance being converted($18,000 of the non-deductible IRA balance) will be taxed asordinary income

Important considerations beoreconverting to a Roth IRA

It is generally not a good idea to convert to a Roth IRAunless you have other funds available outside of yourretirement accounts to pay the taxes. Otherwise, youwill likely be forced to use some of the assets in yourTraditional IRA or 401(k) to pay the taxes, which couldtrigger an early withdrawal penalty on those assets andcreate an even greater tax burden, as well as decreasethe size of your retirement nest egg.

A partial conversion can reduce your tax bill

If you nd that converting an entire account to a Roth IRAcreates too large a tax burden, you may want to considera partial conversion. A partial conversion may allow youto avoid being pushed into a higher tax bracket as a resultof the increase in your reported taxable income. Butbe sure to consider the eects a conversion may haveon your adjusted gross income (AGI). For example, anincrease in AGI may:• Cause Social Security benets to be taxable• Negatively impact itemized deductions likemedical expenses• Result in phase-outs for deductions orpersonal exemptions• Disallow certain tax credits• Result in higher Medicare Part B premiums

Distributions rom a Rothconversion account

In order for a distribution to be free of taxes and penal-ties, it must be considered “qualied.” A qualied Rothdistribution must meet both of these criteria:• The investor has held any Roth IRA for ve years, AND• There must be any ONE of the following “qualifyingevents”: reaching age 59½, rst-time home purchase($10,000 lifetime limit), or disability or death of theaccount owner.For details on taxes and possible penalties for distribu-tions from a Roth conversion account that do not meetboth of these criteria (i.e., “non-qualied” distributions),refer to the chart below:

ScenarioConversionamountEarnings

1) Account converted lessthan 5 years ago and noexception appliesNo taxes, buta 10% penaltyappliesTaxed as income+ 10% penalty2) Account converted atleast 5 years ago and noexception appliesNo taxes orpenaltyTaxed as income+ 10% penalty3) Account convertedless than 5 years ago andexception appliesNo taxes orpenaltyTaxed as income,no 10% penalty

Exceptions include the qualifying events describedabove and certain medical expenses, qualied highereducation expenses, certain payments to purchasehealth insurance in cases of unemployment, and peri-odic payments utilizing IRS rule 72(t). Additionally,special rules apply to determine the order in which Rothcontributions, conversions, and earnings are withdrawn.Consult with a tax professional for assistance.

Roth IRA recharacterization allowsinvestors additional exibility

Roth IRA recharacterization is a rule that essentiallyallows investors to undo a conversion from a TraditionalIRA or other retirement account to a Roth IRA. You haveuntil the tax-ling deadline (generally April 15) or themaximum extension if applicable (generally October 15)to reverse the transaction and place the assets back into aTraditional IRA as if the conversion had never taken place.You can also convert a portion of your assets back into aTraditional IRA through a partial recharacterization.

Possible reasons for recharacterization

• You decide that you don’t want to report as much incomeas a result of the Roth IRA conversion. For example,an investor converting $100,000 to a Roth IRA, uponfurther review of his or her tax situation, may wish torecharacterize half of the assets back into the TraditionalIRA and keep the other half in the Roth IRA.• The IRA decreases in value as a result of market losses.If the value of the IRA decreases after a conversion,recharacterization can help you avoid reporting incomeon your tax return (as a result of the conversion) thatexceeds the actual account value.