Plan for taxes due on a Roth IRA conversion
The Bankrate promise
At Bankrate we strive to help you make smarter financial decisions. While we adhere to strict , this post may contain references to products from our partners. Here's an explanation for .
Roth individual retirement accounts don’t offer an immediate tax savings as do some traditional IRA contributions. Rather, the taxed money you put in a Roth grows tax-free and you owe Uncle Sam nothing when you withdraw the funds as long as you’re at least 59½ and have had the account for at least five years.
Bankrate's 2010 Tax Guide
- Tax tips and tools
- How do I … ?
- Filing and refunds
- Real estate and capital gains
- Family and education
- On the job
- Investments and retirement
- Charitable giving
- Your state taxes
- All guide content
Many people, however, haven’t opened a Roth.
Some prefer the immediate tax deduction that a traditional IRA offers at filing time.
Others weren’t able to open a Roth IRA because they made too much money. You can’t contribute the full amount to a Roth if, as a single filer in 2009, you made more than $120,000; the threshold for joint filers last year was $176,000. In 2010, the $120,000 cap remains for single taxpayers, but the couples’ earning limit is now $177,000.
There also was a $100,000 income limit that prevented individuals from converting a traditional IRA to a Roth account. Now that limit is gone. Regardless of income, anyone can turn a traditional IRA into a Roth.
Even better, any 2010 rollover from a traditional IRA to a Roth gets special tax treatment. Any taxable income included in the rollover doesn’t have to be reported on 2010 taxes. Instead, you can include that money as income in equal amounts in 2011 and 2012 and pay associated taxes when you file those tax returns.
- Is converting worth it?
- Predicting the tax future.
- Expiring tax rates.
- Conversion mechanics.
Decide if converting is worth it
The first step in moving your old IRA money into a Roth is determining whether it’s the best move. You need to ask yourself a few key questions.
What is your time frame? Generally, it makes less sense for older individuals to convert a traditional IRA to a Roth. The reason for that usually is related to the next question.
Do you have cash on hand to pay any conversion taxes? When you convert a regular IRA to a Roth account, you’ll owe taxes on the original account’s earnings and pretax contributions. This tax bill is at your ordinary income tax rate; there is no capital gains break for IRA distributions.
If you must take money out of your IRA to pay those taxes, you’ll put a dent in your retirement account’s compounding power. Plus, if you’re younger than 59½ you also will owe a 10 percent penalty on the converted amount. Essentially, raiding your IRA to pay conversion taxes (and penalties) could offset the possible future gains of tax-free Roth distributions.
And don’t try to avoid conversion taxes by moving only nondeductible money from your traditional IRA. Once funds are in the account, the IRS considers the money blended, meaning you can’t separate deductible and nondeductible amounts.
Finally, don’t forget about other tax breaks. Do you qualify for tax benefits that are based upon your income? Many tax benefits are reduced or eliminated altogether when you make over a certain amount. Will you still be able to claim them after you add the traditional IRA money to your income during the conversion to a Roth account?
Predicting the tax future
What do you expect your retirement tax bracket to be? This obviously is a guessing game. Given the way lawmakers in Washington, D.C., tweak the tax code, it’s often hard to predict tax implications even just a year from now.
However, if you have a good idea that your tax bracket will drop substantially when you retire, you might want to stick with your traditional IRA. That will allow you to pay taxes years from now at a lower rate than what you’ll owe if you convert now.
Similarly, if you think that tax rates will climb dramatically by the time you retire, you might want to convert now. Although we all grumble about them, tax rates are at historic lows. Given the federal deficit and the Obama administration’s plan to let his predecessor’s tax cuts expire at the end of this year, converting and paying taxes now could be a smart move.
About those expiring tax rates
One of the appealing things about converting your IRA in 2010 is that you can defer that income into 2011 and 2012 tax years. You’ll split the taxable amount evenly among the two years and pay taxes when you file those returns.
That means, for example, if you converted $100,000 that is taxable, you can count $50,000 of that as 2011 income and have until April 15, 2012, to come up with the due taxes. The next $50,000 would go into the 2012 tax year, giving you until April 2013 to pay that tax bill.
Of course, those sums could push you into tax rates in 2011 and 2012 that are much higher than they are now. So even if you can spread the conversion over two years, it might be better to pay the full bill in 2010. You do have that option. But the choice to defer is only available for 2010 conversions. If you decide in 2011 to convert a traditional IRA to a Roth, you’ll have to pay all taxes due on your 2011 tax filing.
In addition to answering these questions, you also should run the numbers. Bankrate’s calculator can give you an idea of the change in total net worth, at retirement, if you make the move to a Roth.
One you decide that converting a traditional IRA to a Roth is for you, the process is relatively simple.
If you’re happy with the custodian of your traditional IRA, let that company know that you want to convert the account to a Roth. You’ll have to sign a form or two, but the institution then should handle the rest.
This trustee-to-trustee transfer is the best financial move. It will ensure that you don’t take possession of the rollover money and face possible redeposit problems. When you get a check that’s a distribution from your retirement account, you have 60 days to place the money into another qualifying retirement account. If you miss the deadline, the money is taxable and no longer eligible for rollover.
Once the switch is made, the account custodian will notify you of your federal tax responsibility in connection with the conversion.
Don’t forget Form 8606. If you made nondeductible contributions to your traditional IRA, you should have been filing these each year that you contributed. They will help you account for those already-taxed contributions so that you do not have to pay Uncle Sam on that part of the conversion.
With your new Roth IRA, be sure to name a new beneficiary. This document determines who ultimately gets the account money when you pass away.
Finally, if you earn too much to contribute to a Roth, the removal of the conversion limits offers a work-around. Simply open a traditional IRA and then convert it to a Roth.
And remember, you don’t have to convert your full traditional IRA. If you wish, you can move only a portion of your IRA into a Roth. A partial conversion gives you flexibility to choose how much of your traditional retirement account to move into a Roth and how to deal with the taxes implications of such an asset transfer.