What is Involved in Converting a Traditional IRA to a ROTH IRA?

IRAs are a major piece of the retirement planning puzzle, as they offer a safe, stable investment with some considerable tax advantages. When it comes to IRAs, many financial planners and investors prefer Roth IRAs to Traditional IRAs, for a number of reasons. As long as a number of basic requirements are met, distributions from a Roth IRA are tax-free. Roth IRAs also do not require minimum distributions at age 70 and ½. In fact, a Roth IRA can be passed on with a tax-free income stream to your heirs. Before converting your Traditional IRA into a Roth IRA, there are a few important aspects of the process to consider.

Is a Roth IRA Right for You?

One of the key differences between Roth and Traditional IRAs is the tax structure of contributions. With a Roth IRA, you will be making contributions with money that has already been taxed, which allows the funds in the IRA to grow tax-free for an indefinite period. Withdrawals of Roth IRA earnings are not subject to federal income tax or penalties, as long as certain, easily-attainable conditions have been met. In Traditional IRAs, contributions can be made with pre- or after-tax dollars, with pre-tax contributions and earnings subject to federal income taxes when withdrawn.

For either type of IRA, distributions taken before the age of 59 and ½ may be subject to both ordinary income taxes and a 10 percent early-withdrawal penalty. With a Roth IRA, all distributions are tax-free as long as the holder of the IRA is either more than 59 and ½ years of age, disabled, or deceased. Another key benefit of the Roth IRA is that you are not forced to take minimum required distributions after age 70 and ½, which can be helpful both in your retirement planning, and in planning for the inheritance of your heirs.  The Traditional IRA requires you to take minimum distributions once you reach age 70 and ½.

About the Conversion Process 

You can choose to convert either a Traditional IRA, Rollover IRA, SEP IRA, SIMPLE IRA, SARSEP IRA, 401(k), 403(b) or 457(b) into a Roth IRA.

If you choose to convert any type of account that includes pre-tax contributions into a Roth IRA, you will be subject to income tax on those contributions in the year of conversion. However, the 10 percent early distribution penalty will not apply to the converted amounts.

Income limits for Roth IRAs, which at one time were capped at $100,000 per year, no longer apply. However, there are still limits on annual contributions to any type of IRA.

If you choose to convert to a Roth IRA, the process is relatively simple, and can be done with the help of any reputable financial adviser. The key factor to consider with a conversion is whether you have the funds available in a non-retirement account to pay any income taxes on conversion. You will want to avoid paying those taxes with IRA conversion proceeds because it will diminish the value of your IRA.

If you decide to change your mind about the conversion, you will be permitted to recharacterize a Roth IRA back to a Traditional IRA by the due date of your tax return with extensions. If your IRA has decreased in value since conversion, your taxable income is more than what you expected, a conversion moves you to a higher tax bracket, or you do not have the funds to cover the tax bill resulting from conversion are all reasons to consider a recharacterization.

Overall, a Roth IRA conversion should be a consideration when planning for your retirement. It is important to consider all of the relevant factors prior to making that choice.  

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