Conversions of Traditional to Roth IRAs
Starting in tax year 2010, most taxpayers are allowed to convert a Traditional IRA into a Roth IRA. Other accounts may be available for conversion into a Roth IRA as well, such as SEP IRAs and SIMPLE IRAs. For those taxpayers who feel they may benefit from the tax advantages of a Roth IRA over a Traditional IRA, depending on their own facts and circumstances, the following should be considered before choosing to convert:
In the year of conversion, a taxpayer will owe income taxes on the "conversion amount". The conversion amount represents any monies contributed to a Traditional IRA that were made on a pre-tax basis (i.e., a deduction was claimed when the contribution was made).
Special Rule: For conversions made in tax year 2010, the taxpayer can choose to spread the conversion amount evenly over tax year 2011 and 2012, paying any tax due on the conversion amount in those years.
Income Tax Rates: What are the current income tax rates during the working years vs. the expected income tax rates during the retirement years? Consideration should be given to both federal and state rates (if the taxpayer resides in a state where income tax is assessed).
Required Minimum Distribution (RMD): Roth IRAs do not have a RMD rule unlike Traditional IRAs. A RMD is a required distribution a taxpayer must take from a Traditional IRA once a taxpayer reaches age 70 ½. However, the Roth IRA allows a taxpayer more control over their effective tax rate by taking more or less money from the Roth IRA, depending upon what the income tax rates are during the retirement years.
Estate Planning: A Roth IRA can be passed on to the heirs of an estate and such heirs can take distributions from the Roth IRA over their lifetime. This provides for tax-free growth of the Roth IRA account over the heir's lifetime, allowing for additional growth opportunities for the account. A Roth IRA is, however, subject to estate taxes should the decedent have a taxable estate.
Payment of Conversion Taxes: When a Traditional IRA is converted into a Roth IRA, any pre-tax contributions, plus any earnings, will be taxed at the taxpayer's ordinary income rates. In order to maximize the benefits of conversion, it is preferable to pay any tax due from conversion with assets outside of the IRA. This allows for tax-free growth of such assets that would otherwise require distributions from the IRA to pay income taxes (and potentially be assessed a 10% penalty, in addition to income taxes for the distribution).