For many people, the Roth IRA is clearly the better choice over a regular IRA. However, what if you already have a traditional IRA? Can you wave your magic wand and turn it into a Roth? Perhaps... it depends on whether your wand meets certain conditions.
Conversion must be qualified
The term "qualified rollover" can get a little complex, but it is basically a rollover that meets the 60-day rollover time period, and is not in violation of the "one-year" rollover rules. For additional information regarding qualified rollovers, see IRS Publication 590, "Individual Retirement Arrangements."
Adjusted gross income limitations
Assuming you can get over the "qualified" distribution rules, you still have one other hurdle to clear -- the adjusted gross income (AGI) limitations. The law states that if your AGI is greater than $100,000, you may not convert from a traditional IRA to a Roth IRA.
This $100,000 limitation applies not only to single filers, but also to married people filing jointly and head-of-household filers. Furthermore, don't think you can beat the AGI limitations by filing a married-separate tax return. You can't. The law specifically states that if you are a married taxpayer filing a separate tax return, you may not convert your traditional IRA to a Roth IRA, regardless of your AGI.
(Note: What if you made a Roth conversion last January and now find that your AGI will exceed the $100,000 limitation? First, don't panic. You have the ability to "re-characterize" your Roth IRA back to a traditional IRA without penalty if you follow a few simple steps. Second, read more about how to follow those steps in our Tax Area article "Recharacterizations.")
And remember that the AGI limitations are computed without regard to the amount of the conversion.
Jack, a single person, has an AGI of $75,000. Jack also has a traditional IRA in the amount of $60,000 that he wants to convert to a Roth IRA. For AGI limitation purposes, Jack's conversion threshold is $75,000 (the amount of his "normal" AGI, without regard to the conversion amount), and not the total of his "normal" AGI and his "conversion" amount. Jack's AGI for income tax purposes will change if he decides to make this conversion, but that's an issue that we'll discuss in detail a little later.
Conversion Taxation Issues
OK, you've decided that you can make a Roth conversion. Now you need to know more about the tax issues involved in making the conversion.
In effect, the funds converted from the traditional IRA to the Roth IRA that would have been taxable had the distribution not been part of a qualified conversion will be subject to income tax at your normal tax rate. If your IRA consists only of prior deductible contributions and the earnings thereon, the total amount of the conversion will be subject to taxation.
If part of your IRA consists of prior nondeductible contributions, they will not be taxed again at the time of the conversion.
And if your IRA consists of funds from a prior rollover from another qualified pension plan (such as a pension/profit sharing plan, 401(k) plan, 403(b) plan, Keogh plan, SEP plan, etc.), all of the funds will be taxable to you at the time of the conversion.
Because the conversion is "qualified," the 10% penalty for an early withdrawal from an IRA account will not be imposed. In effect, the conversion can be made without paying the 10% IRA early withdrawal penalty. But should you decide to remove these converted funds "early" from the Roth IRA, you may be subject to a penalty. Early withdrawal penalty issues are discussed here.
Confused? No need. Let's continue with the example of Jack and his conversion.
Jack's AGI is $75,000, and he made a $60,000 conversion from his regular IRA to a Roth IRA this year. Now Jack's AGI for income tax purposes will be $135,000 (his regular AGI of $75,000 plus all of his conversion income of $60,000).
Jack will not be hit with a 10% early withdrawal penalty on the amount of the IRA converted to the Roth IRA (assuming Jack keeps his nose clean and doesn't take the funds out of his Roth IRA "early").
Finally, as noted above, all of the tax issues that use AGI for a benchmark (except Roth contributions and conversions) will now be based on Jack's new AGI of $135,000 for this tax year. So, his medical threshold is 7.5% of $135,000. His miscellaneous itemized deduction threshold is 2% of $135,000.
Jack decided to pay more tax dollars to Uncle Sammy right now. In effect, Jack is trading tax dollars now for the tax-free status of the Roth earnings in the future. Is that appropriate? Perhaps for Jack, based on his personal situation, the answer is yes. But it is not necessarily appropriate for everyone. In fact, for some people, converting a regular IRA to a Roth IRA might actually cost them additional tax dollars in the long run.
That is why the Roth IRA conversion debate has become very heated. The decision to make this conversion is very personal, based on personal status, goals, age, intentions, etc. Therefore, the "to convert or not" question can only be answered by you, based on your personal financial, estate, and tax situation. An excellent overview of these issues appears in our article " Convert to a Roth IRA?"
You can find Roth IRA conversion "calculators" all over the Web to help you with your decision (test several or read reviews first to make sure the calculator you use matches your personal situation best -- not all calculators are created equal). We have IRA calculators to help you chose between a regular IRA and a Roth IRA and decide whether to convert an IRA into a Roth IRA.
You can also check out other sites that deal with Roth conversion decision issues. Two of the very best include the Fairmark tax site and the Roth IRA site. Before you make your final decision, you should take the time to read what these sites have to say about the pros and cons as well as their reviews of various calculators.
Next we'll look at distributions from a Roth IRA and what impact those distributions may have on your tax situation.