Converting IRAs to Roth IRAs

Roth IRAs have some features that make them more attractive than distributions from the account are exempt from taxes and penalties. (On the other hand, your contributions to a Roth IRA are funded with after-tax dollars.)

Your entire Roth IRA balance may also be distributed tax- and penalty-free if you have held the account for at least five years and are disabled, are taking out up to $10,000 to buy a first home, or payments are being made to a beneficiary or your estate after your death.

A second advantage of Roth IRAs is that they do not require minimum distributions (RMDs). As a result, you have more flexibility in managing your estate. Instead of taking distributions that you may not need but are required to take, you can leave the money to your beneficiaries.

Tax laws let you convert the assets in a regular IRA to a Roth IRA in a process called a Roth conversion. To complete a Roth conversion, use a Roth rollover or trustee-to-trustee transfer.

Converting the assets in a regular IRA to a Roth IRA is a trade-off. On one hand, you owe taxes in the year that you convert. This is because you are moving assets from a tax-deferred account funded with tax-deductible contributions to a retirement account funded with after-tax contributions.

For example, assume you convert a regular IRA with $100,000 in assets to a Roth account. If you're in the 25% income tax bracket, you would owe $25,000 in income taxes in the year of the conversion.

A major consideration in choosing to convert to a Roth IRA is your expected future tax bracket. When you retire, your income is likely to drop. This may push you into a lower tax bracket. As a result, your distributions from a retirement account are less heavily taxed. While taxation of distributions is a moot point for qualified Roth IRAs, taxation affects the value of distributions from regular IRAs.

The basic rule of thumb is if you expect to be in the same (or higher) tax bracket when you become eligible for distributions, a Roth IRA has extra appeal. Conversely, if you expect to be in a lower tax bracket, a regular IRA has extra appeal.

Roth conversions are not as attractive as they were in 1998, the first full year that Roth IRAs were in existence. At that time, there was a one-time rule that year allowed investors to spread out the tax impact of conversions over four years.

A Roth conversion may make sense if the account grows enough in the future to make up for the bigger tax bill you face when you convert. You may wish to remember the following on Roth conversions:

Income limit and tax filing status. You are allowed to convert a regular IRA to a Roth IRA if your modified adjusted gross income (MAGI) does not exceed $100,000. You also cannot convert if you are married and you and your spouse are filing separate tax returns.

Timing to avoid penalty. You can avoid an early-withdrawal penalty equal to 10% of the conversion amount if you complete a Roth rollover within 60 days. If you are under 59 1/2 years old and keep any of the withdrawal or miss the 60-day rollover period, you should plan on paying the penalty.

Receiving RMDs on a regular IRA. If you are already receiving RMDs from a regular IRA, you cannot convert the RMD amount to a Roth IRA. You can convert any portion that is not part of the RMD.

For more information on Roth IRA conversions, see IRS Pub. 590: "Individual Retirement Arrangements."

The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax adviser.