With the lure of tax-free distributions, Roth IRAs have
become increasingly popular retirement savings vehicles. According to the
Investment Company Institute, 19.1 million U.S. households (about 15.6%)
owned Roth IRAs in 2013.
(Source: 2014 Investment Company Fact Book)
If you make a Roth conversion and it turns out not to be
advantageous (for example, the value of your investments declines
substantially), IRS rules allow you to "undo" the conversion.
You generally have until your tax return due date (including extensions)
to undo, or "recharacterize," your conversion.
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Roth IRA Conversions
With the lure of tax-free distributions, Roth IRAs have
become increasingly popular retirement savings vehicles. According to the
Investment Company Institute, 19.1 million U.S. households (about 15.6%)
owned Roth IRAs in 2013.
What are the
general rules for funding Roth IRAs?
There are three ways to fund a Roth IRA--you can contribute
directly, you can convert all or part of a traditional IRA to a Roth IRA,
or you can roll funds over from an eligible employer retirement plan.
In general, you can contribute up to $5,500 to an IRA
(traditional, Roth, or a combination of both) in 2014 ($6,500 if you'll
be age 50 or older by December 31). However, your ability to make annual
contributions may be limited (or eliminated) depending on your income
level ("modified adjusted gross income," or MAGI), as shown in
the chart below:
If your federal filing status is:
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Your 2014 Roth IRA contribution is reduced if your
MAGI is:
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You can't contribute to a Roth IRA for 2014 if your
MAGI is:
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Single or head of household
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More than $114,000 but less than $129,000
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$129,000 or more
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Married filing jointly or qualifying widow(er)
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More than $181,000 but less than $191,000
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$191,000 or more
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Married filing separately
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More than $0 but less than $10,000
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$10,000 or more
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Unlike a traditional IRA, you can contribute to a Roth IRA
even if you're 70½ or older. However, your contributions generally can't
exceed your earned income for the year (special rules apply to spousal Roth
IRAs).
Important
changes since 2010
Prior to 2010, you couldn't convert a traditional IRA to a
Roth IRA (or roll over non-Roth funds from an employer plan to a Roth
IRA) if your MAGI exceeded $100,000 or you were married and filed
separate federal income tax returns.
The Tax Increase Prevention and Reconciliation Act (TIPRA),
however, repealed the $100,000 income limit and marital status
restriction, beginning in 2010. What this means is that, regardless of
your filing status or how much you earn, you can now convert a
traditional IRA to a Roth IRA. (There's one exception--you generally
can't convert an inherited IRA to a Roth. Special rules apply to spouse
beneficiaries.)
And don't forget your SEP IRAs and SIMPLE IRAs. They can
also be converted to Roth IRAs (for SIMPLE IRAs, you'll need to
participate in the plan for two years before you convert). You'll need to
set up a new SEP/SIMPLE IRA to receive any additional plan contributions
after you convert.
How do you
convert a traditional IRA to a Roth?
Converting is relatively simple. You start by notifying your
existing traditional IRA trustee or custodian that you want to convert
all or part of your traditional IRA to a Roth IRA, and the
custodian/trustee will provide you with the necessary paperwork.
You can also open a new Roth IRA at a different financial
institution, and then have the funds in your traditional IRA transferred
directly to your new Roth IRA. The trustee/custodian of your new Roth IRA
can give you the paperwork that you need to do this. If you prefer, you
can instead contact the trustee/custodian of your traditional IRA, have
the funds in your traditional IRA distributed to you, and then roll those
funds over to your new Roth IRA within 60 days of the distribution. The
income tax consequences are the same regardless of the method you choose.
Calculating the
conversion tax
When you convert a traditional IRA to a Roth IRA, you're
taxed as if you received a distribution, but with one important
difference--the 10% early distribution tax doesn't apply, even if you're
under age 59½. However, the IRS may recapture this penalty tax if you
make a nonqualified withdrawal from your Roth IRA within five years of
your conversion.
If you've made only nondeductible (after-tax) contributions
to your traditional IRA, then only the earnings, and not your own
contributions, will be subject to tax at the time you convert the IRA to
a Roth. But if you've made both deductible and nondeductible IRA
contributions to your traditional IRA, and you don't plan on converting
the entire amount, things can get complicated.
That's because under IRS rules, you can't just convert the
nondeductible contributions to a Roth and avoid paying tax at conversion.
Instead, the amount you convert is deemed to consist of a pro rata
portion of the taxable and nontaxable dollars in the IRA.
For example, assume that your traditional IRA contains
$350,000 of taxable (deductible) contributions, $50,000 of nontaxable
(nondeductible) contributions, and $100,000 of taxable earnings. You
can't convert only the $50,000 nondeductible (nontaxable) contributions
to a Roth, and have a tax-free conversion. Instead, you'll need to
prorate the taxable and nontaxable portions of the account. So in the example
above, 90% ($450,000/$500,000) of each distribution from the IRA
(including any conversion) will be taxable, and 10% will be nontaxable.
You can't escape this result by using separate IRAs. Under
IRS rules, you must aggregate all of your traditional IRAs (including
SEPs and SIMPLEs) when you calculate the taxable income resulting from a
distribution from (or conversion of) any of the IRAs.
Some experts suggest that you can avoid the pro rata rule
and make a tax-free conversion if you take a total distribution from all
of your traditional IRAs, transfer the taxable dollars to an employer
plan like a 401(k) (assuming the plan accepts rollovers), and then roll
over (convert) the remaining balance (i.e., the nontaxable dollars) to a
Roth IRA. The IRS has not yet officially ruled on this technique, so be
sure to get professional advice before considering this.
Using
conversions to make "annual contributions"
Unfortunately, TIPRA didn't repeal the income limits that
may prevent you from making annual contributions to your Roth IRA. But if
your income exceeds these limits, and you want to make annual Roth
contributions, there's an easy workaround: you can make nondeductible
contributions to a traditional IRA, as long as you haven't yet reached
age 70½. You simply make your annual contribution first to a traditional
IRA, and then convert that traditional IRA to a Roth. There are no limits
to the number of Roth conversions you can make. (But again, you'll need
to aggregate all of your traditional IRAs--including SEPs and
SIMPLEs--when you calculate the taxable portion of the conversion.)
Employer
retirement plans
You can also roll over non-Roth funds from an employer plan
(like a 401(k)) to a Roth IRA. Prior to 2010, the income limits and
marital status restrictions also applied to employer plan rollovers to
Roth IRAs (commonly referred to as conversions). As with traditional IRA
conversions, TIPRA removed these restrictions beginning in 2010, and now
anyone can roll over funds from an employer plan to a Roth IRA, regardless
of income level or marital status. Like traditional IRA conversions, the
amount you convert will be subject to income tax in the year of
conversion (except for any after-tax contributions you've made).
Is a Roth
conversion right for you?
The answer to this question depends on many factors,
including your current and projected future income tax rates, the length
of time you can leave the funds in the Roth IRA without taking
withdrawals, your state's tax laws, and how you'll pay the income taxes
due at the time of the conversion.
And don't forget--if you make a Roth conversion and it turns
out not to be advantageous (for example, the value of your investments
declines substantially), IRS rules allow you to "undo" the
conversion. You generally have until your tax return due date (including
extensions) to undo, or "recharacterize," your conversion. For
most taxpayers, this means you have until October 15, 2015, to undo a
2014 Roth conversion.
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