Convert a Traditional IRA to a Roth IRA

Can you convert a Traditional IRA to a Roth IRA?

Yes.

In fact, for years, you could only convert a Traditional IRA, a SIMPLE IRA, or a SEP IRA to a Roth IRA. But in 2008, the rules changed to include numerous other traditional retirement savings plans such as your 401k, 403b, etc. So you now have a wide array of choices when it comes to a Roth IRA conversion.

But converting your Traditional IRA to a Roth remains one of the most common conversion types. And as long as you're willing to face the tax consequences, it's a rather simple process.

What Are The Traditional IRA Conversion Rules?

Obviously, if you want to convert a Traditional IRA to a Roth IRA, you need to know the rules.

So what are the Traditional IRA conversion rules?

As a general rule, you need to perform the following actions to have a successful conversion...

• Have adjustable gross income (AGI) under the IRS limits (prior to 2010)
• Move distributions from your Traditional IRA to your Roth IRA within 60 days
• Pay taxes on conversion distributions, if necessary

Cover these three points, and converting your Traditional IRA to a Roth IRA should be a seamless process. So let's examine each point in greater detail...

IRS Income Limits and 2010 Roth IRA Conversions

Before you make any attempt to convert a Traditional IRA to a Roth IRA, you need to meet the eligibility requirements.

So how do you do that?

Under current law, you must have adjustable gross income (AGI) of $100,000 or less. If your annual income exceeds that limit, you're ineligible to perform a conversion. And this limit applies to everyone, regardless of tax filing status.

For instance, let's say you're married, you're 45 years old, and you earn $125,000 per year. Under the law, you're eligible to make the maximum $5,000 contribution to your Roth IRA, because your income is below the $166,000 limit for doing so. But if you have a Traditional IRA you'd like to convert to a Roth IRA, you can't do so.

Why?

Because you earn more than the $100,000 limit for performing a Roth IRA conversion.

However...

That limit doesn't last forever.

Starting in 2010, the $100,000 AGI limit for Roth IRA conversions disappears.

Did you catch that?

The $100,000 conversion limit simply goes away...

That means anyone, regardless of income or tax filing status can perform a Roth IRA conversion starting in 2010. And, under the 2010 Roth IRA conversion rules, you can take advantage of a one-time tax deferral option, for the year 2010 only, which allows you to defer taxes until 2011 and 2012.

So if you've previously found yourself locked out of the ability to perform a Roth IRA conversion due to your high annual income, take advantage by converting in 2010 before Congress changes the rules yet again...

How To Convert a Traditional IRA to a Roth IRA

So how do you convert a Traditional IRA to a Roth IRA?

It's a fairly straightforward process, and you generally have three options at your disposal...

1) Rollover - You can take a distribution of funds from your Traditional IRA and "roll it over" (that's financial lingo for "contribute it") to your Roth IRA within 60 days of receiving the distribution. Just remember, you only have 60 days to get those funds into your Roth IRA before your conversion window of opportunity permanently closes. If you go over the 60 day limit, you'll get hit with a 10% early withdrawal penalty if you're under age 59 ½.

2) Trustee-to-Trustee Transfer - You can instruct the trustee (the firm where your account resides) of your Traditional IRA to directly transfer funds to the trustee of your Roth IRA account. If you choose this option, the two trustees should be familiar with the process and walk you through step-by-step.

3) Same Trustee Transfer - If your Traditional IRA is overseen by the same trustee who oversees your Roth IRA, then you can direct the trustee to simply transfer funds from your Traditional IRA to your Roth IRA. You also have the option to simply redesignate your Traditional IRA as a Roth IRA, rather than open a new account. Of course, if you choose this method, you still owe income taxes on the full amount of your conversion...

Taxes Due From Your Conversion

If you convert a Traditional IRA to a Roth IRA, you're most likely going to trigger an income tax liability on the converted amount.

Any deductible contributions and/or any investment gains are then subject to income tax at your current income tax rate.

For instance, let's say you have a Traditional IRA worth $200,000, and you're in the 25% tax bracket. If you convert your Traditional IRA to a Roth IRA, you generate a tax bill of $50,000 ($200,000 x 25%).

And how you pay that tax bill profoundly impacts your retirement savings.

You only have two ways to pay your Roth IRA conversion tax bill:

1) With Funds From Your Traditional IRA - You can use a portion of the funds from your Traditional IRA to pay your conversion taxes. However, any withdrawn funds not transferred into your Roth IRA within 60 days are subject to a 10% early withdrawal penalty if you're under age 59 ½.

2) With Funds From Your Personal Savings - You can pay your conversion taxes with out-of-pocket funds from your salary or personal savings.

In the first instance, you end up with less money in your Roth IRA.

In the second instance, all the funds from your Traditional IRA end up in your Roth IRA.

Out of the two options, which one do you prefer?

Obviously, if you have the means to pay the conversion taxes out-of-pocket, that's the best course of action.

Why?

Here's why...

Let's say you have $100,000 in your Traditional IRA, and you're in a 20% tax bracket. If you perform a Roth IRA conversion of the full $100,000, you generate $20,000 in conversion taxes.

If you pay the $20,000 tax bill out-of-pocket, you end up with $100,000 in your Roth IRA, and everything is great.

Pretty simple, right?

But what if you don't have an extra $20,000 to pay your tax bill?

In that case, you can use funds from your Traditional IRA to pay the bill.

But there's only one problem with that...

If you use $20,000 of your $100,000 in funds to pay the tax bill, the $20,000 is subject to a 10% early withdrawal penalty if you're under age 59 ½. That means you owe the IRS an additional $2,000.

Assuming you do have $2,000, then you end up with $80,000 in your Roth IRA and $2,000 out of your pocket. But if you don't have $2,000 and need to dip into your Traditional IRA, then you trigger an additional 10% early withdrawal penalty on the extra $2,000.

Do you see why it's best to pay your conversion taxes out-of-pocket if at all possible?

Non-Deductible Traditional IRA Contributions

If you earn too much to make deductible contributions to your Traditional IRA, then the IRS allows you to make non-deductible contributions, regardless of how much you earn.

Any non-deductible contributions in your Traditional IRA are NOT subject to income tax when you convert a Traditional IRA to a Roth IRA. However, any investment gains on your non-deductible contributions ARE subject to taxation.

Why does this matter?

Two reasons.

First, past non-deductible contributions lower your overall conversion tax bill, and...

Second, after the new 2010 Roth IRA conversion rules take effect, you can use non-deductible Traditional IRA contributions to your advantage.

How?

Let's say you're married and earn $200,000 per year...

According to the Roth IRA income limits, you?re ineligible to make a Roth IRA contribution because you earn more than $176,000 per year.

As a result, you can NOT contribute to your Roth IRA.

However, because the $100,000 adjustable gross income (AGI) limit on performing a Roth IRA conversion disappears, you are able to make non-deductible contributions to a Traditional IRA. Then, you can quickly turn around and convert a Traditional IRA to a Roth IRA. And since non-deductible contributions are NOT taxable as a result of a conversion, your entire conversion is tax-free.

In a sense, you just made a Roth IRA contribution, even though you technically earn too much to do so.

Conclusion

If you want to convert a Traditional IRA to a Roth IRA, make sure you...

• Have adjustable gross income (AGI) under the IRS limits (prior to 2010)
• Move distributions from your Traditional IRA to your Roth IRA within 60 days
• Pay taxes on conversion distributions, if necessary

Also, be aware of the changes to the 2010 Roth IRA conversion rules which eliminate the $100,000 income limit restricting who can and cannot perform a conversion.

If you currently earn too much to make a direct Roth IRA contribution, you might want to consider making non-deductible contributions to a Traditional IRA. Then, after 2010 arrives, you can convert the Traditional IRA to a Roth IRA.