When to Consider a Roth IRA Conversion.

There are many advantages to having a Roth IRA as part of your retirement savings plan. It allows you to set aside after-tax income, up to a specified amount each year. Once you have owned your account for five years and you are age 59½ or over, both earnings on the account and withdrawals are tax-free. You don’t need to take required minimum distributions starting at age 70½, as you do with a Traditional IRA.  You can pass your Roth IRA on to your beneficiaries and their withdrawals will be tax-free. 

Everyone can convert their eligible retirement account to a Roth IRA regardless of income or marital status. Prior to 2010, only those account owners who had a modified adjusted gross income below $100,000 were eligible to convert. If your earned income exceeds the current income limit, you may still be able to contribute to a Roth IRA by using a “backdoor” contribution process. “Backdoor Roth IRA” is an informal name for the process that allows high-income taxpayers to take a roundabout path to invest in a Roth IRA. To do this, open a Traditional nondeductible IRA and make a regular contribution. As soon as the contribution posts, convert it to a Roth IRA. Assuming you have no other IRA assets, the only taxes due on the conversion would be any appreciation in the investment since you opened the account. Be aware that if you do have other (non-Roth) IRAs, the taxable portion of any conversion is prorated over all of your IRAs (Backdoor Roth IRA).  

Not everyone can start a Roth IRA or continue to fund an existing Roth IRA. There are many rules involved which are outlined in the post, “There Are Some Roth IRA Rules You Need to Know”.

What can you convert?

  • Traditional IRA
  • SIMPLE IRA (after two years)
  • SEP IRA
  • Employer retirement plan (401, 403(b), and 457(b)) assets
  • Designated Roth Account (401(k), 403(b), or 457(b) )

Having the option of a Roth conversion doesn’t automatically make it a good idea for your specific financial situation. Generally, converting to a Roth IRA makes sense in the following situations:

  • You expect your tax rate to stay the same or to go up in retirement. 
  • You have enough money to pay the tax bill created by the conversion without dipping into your IRA.
  • You want to avoid paying required minimum distributions at age 70 1/2. 
  • You plan on leaving money to your beneficiaries in an account that they can take withdrawals tax-free. For non-spouse beneficiaries, Roth IRAs are subject to the required minimum distribtution rule, but this is not the case for spousal beneficiaries.
  • You have large government or military pensions and/or Social Security payments that will place you in high tax brackets.  

If you are close to retirement and will be withdrawing the money soon, you probably will not have time to earn large enough returns to make the conversion cost worth it. 
 

How to convert to a Roth IRA:
Most major brokerage firms make it easy to convert to a Roth IRA.  Some methods include:

  • Rollover – You receive a distribution and contribute it to a Roth IRA within 60 days after the distribution (the distribution check is payable to you).
  • Trustee-to-trustee transfer – You tell the financial institution holding your assets to transfer an amount directly to the trustee of your Roth IRA at a different financial institution (the distributing trustee will issue you a check payable to the new trustee).
  • Same trustee transfer – If your Traditional and Roth IRAs are maintained at the same financial institution, you can tell the trustee to transfer an amount from your Traditional IRA to your Roth IRA.

You have the option to "undo" your conversion.
If you convert to a Roth IRA and later decide to undo it, you can. This process is called recharacterization. For example, if you convert and later discover you are in a higher tax bracket than you anticipated, the cost for the conversion could be more than you planned on. You can recharacterize a conversion any time up to the income-tax-filing deadline, plus extension, for the tax year of the conversion. For example, if you converted in the 2013 tax year, you can recharacterize as late as October 15, 2014.

If you recharacterize a contribution and decide you would like to convert back to a Roth IRA, you can reconvert that amount. Be aware of the time restrictions for reconverting. You will need to wait until the beginning of the tax year following your initial conversion, or before 30 days after the day you recharacterized your contribution, whichever is later.

 

Carol Chaudet