Converting a traditional IRA

Those who lack the personal savings to cover the tab often use money from their traditional IRA, which is ill-advised.

"It is preferable for an account holder to use non-IRA funds to pay the conversion taxes," says Nick Kaster, senior analyst at Wolters Kluwer. "First, by paying the tax on the conversion out of other assets, the full amount of the IRA is allowed to grow tax-deferred. In addition, because funds are not being drawn from the IRA, they will not be subject to the 10 percent penalty on distributions received prior to age 59 1/2."

The other potential drawback to a Roth conversion is that it could push you into a higher tax bracket, especially if you've accumulated sizable earnings over the years. (Only the portion of your income that falls into that new bracket will be taxed at the higher rate.)

To minimize the upfront tax hit of a conversion and avoid the higher tax rate, some financial planners suggest moving a portion of your traditional IRA to a Roth over the course of several years.

Kaster, however, notes retirement savers must first consider their income, tax rate and age.

"Individuals and their planners need to run the numbers to determine if a total or partial conversion works for them," he says.

You may need help anyway determining how much of your converted savings are taxable, particularly if you have deductible and nondeductible money in your IRA.

For those willing to go it alone, the IRS provides a work sheet to help calculate the taxable part of an IRA in Publication 590.

Will it pay?

Generally, converting to a Roth IRA makes sense for those who expect their federal tax rate to remain the same or go up after retirement, since their earnings would not be subject to tax upon withdrawal.

Younger employees are also more likely to benefit because they have a longer time horizon to make up for the immediate tax hit and more years to benefit from compounded growth.

Older individuals, however, who are financially well-positioned and approaching age 70 1/2, when required minimum distributions begin for their regular IRA, may also do well by converting part of their savings to a Roth.

Such a strategy helps lower the value of their regular IRA and as a result, reduces their required minimum distributions. In addition, access to tax-free money affords retirees flexibility when it comes to taking retirement plan distributions.

It also, of course, gives their earnings a chance to grow tax-free for as long as they like.

Finally, those focused on estate planning are good candidates for a Roth conversion as well, says Kaster.

"If the IRA owner's main priority is to provide for heirs at death, then conversion to a Roth makes sense," he says. "Because no minimum distributions are required from a Roth (unlike with a traditional IRA), a Roth is superior to a traditional IRA as a vehicle to pass on wealth, since the assets can sit in the account and accumulate."

Need money soon?

If you think you might need to withdraw from your Roth within five years of your conversion, however, you should plan to leave your money in a traditional IRA.

Distributions of earnings made from a Roth that is less than 5 years old are subject to the 10 percent early withdrawal penalty.

Consult your tax adviser to determine whether a Roth rollover is right for you.


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