Roth IRA Conversion Rules

What are the Roth IRA conversion rules?

That's a great question.

Because under the old rules for Roth IRA conversions, you could only convert a Traditional IRA, a SEP IRA, or a SIMPLE IRA to a Roth IRA. But a few years ago, all that changed.

So it's a good idea to review the rules if you haven't looked at them lately.

As of 2008, you can roll over all, or part, of an eligible distribution from your (or your deceased spouse's)...

• 401k
• 403b
• 457 plan
• Employer qualified pension
• Profit-sharing plan
• Stock bonus plan, or
• Annuity plan

And, of course, your Traditional, SEP, and SIMPLE IRA'S all remain eligible as well.

Who Qualifies?

However, even if you have one of these eligible plans, you may not qualify for a Roth IRA conversion.

Under the Roth IRA conversion rules, you're NOT qualified to perform a conversion if...

1) You're married filing a separate tax return and you lived with your spouse for part of the year (in 2010, this provision will be eliminated)

2) You inherited the account you wish to convert from someone other than your spouse. In such a case, the inherited account can NOT be converted to a Roth IRA.

3) You have adjustable gross income (AGI) in excess of $100,000 (this provision also disappears in 2010)

Assuming you're still eligible, you need to perform the following tasks, which are standard procedure for Roth IRA conversions...

• Open/establish a Roth IRA account to move funds into
• Move rollover distributions from your converted account to your Roth within 60 days
• Pay taxes on any Roth IRA conversion distributions (if necessary)

If you carefully follow all the Roth IRA conversion rules, nothing should stop you from having a successful conversion experience...

An Open Roth IRA Account

If you perform a Roth IRA rollover, you need to have an open Roth account to roll your funds into. But if you take advantage of other conversion methods, you might choose a direct rollover method which allows you to simply change the designation of your account or move funds into an account created for that purpose.

For instance, if you perform a same trustee transfer, you don't necessarily need to have an open Roth IRA account. Your account trustee can open one or re-designate your current account for you.

For example, let's say you have a Traditional IRA worth $40,000 with Fidelity. You decide to convert your Traditional IRA to a Roth IRA, which you also plan to hold through Fidelity. In this case, Fidelity can simply change the designation of your Traditional IRA to "Roth IRA," and the transaction is complete.

Or, if you want only a partial conversion, you can choose to take half of your Traditional IRA and convert it to a Roth. In such a case, your Traditional IRA remains intact, with $20,000 in it, while a new $20,000 Roth IRA account is opened with Fidelity.

Roth IRA Conversion Adjustable Gross Income (AGI) Limits

Under current Roth IRA conversion rules, you can NOT perform a conversion if your adjustable gross income (AGI) exceeds $100,000 for the tax year in which you wish to make a conversion.

For instance, let's say you have a 401k worth $85,000, and you earn $105,000 per year. Under current rules, you're barred from converting your 401k to a Roth IRA. But if you only earn $90,000 in the following year, you become eligible to make a conversion.

All that said, the 2010 Roth IRA conversion rules aim to make all of the past rules irrelevant.

Why?

Because in 2010, the $100,000 income limit on Roth IRA conversions expires. That means anyone will be able to perform a Roth IRA conversion, regardless of income level.

For example, let's say you have a Traditional IRA you wish to convert to a Roth IRA, and your current annual income is $255,000. Under the current Roth IRA conversion rules, you can NOT make a conversion. But in 2010, you can...

A 60 Day Deadline To Fund Your Roth IRA

In order to adhere to the Roth IRA conversion rules, you must meet the 60 day rule.

If you elect to perform a conversion which results in you personally receiving a check from the administrator or trustee of your current retirement plan, you have only 60 days from the day you receive those funds to roll them over (contribute them) to your Roth IRA.

If you fail to complete the Roth IRA rollover process within the 60 day period, you effectively forfeit your right to perform a conversion, and taxes and early withdrawal penalties (if triggered) are due.

For instance, let's say you have a $105,000 401k with your present employer, and you decide to switch careers. Most likely, you'll be given the option of rolling your old 401k funds into the 401k program of your new employer or converting your old 401k to a Roth IRA.

If you choose to convert to a Roth IRA, your plan administrator might send you a check. From the day you receive the check, you have 60 days to deposit that check into your Roth IRA account.

However, if you find yourself in this situation, make sure the check you receive is for the full amount of the conversion. By law, most plan administrators will keep 20% of your conversion funds for tax withholding purposes. And that can pose a problem...

Why?

Because those funds are also subject to the 60 day rule.

For instance, sticking with our earlier example, you decide to convert a $105,000 401k to a Roth IRA. If your plan administrator keeps 20% ($21,000 for tax withholding purposes) and strikes you a check for $84,000, you still need to fund your Roth IRA to the tune of $105,000 within the 60 day period.

So, under the Roth IRA conversion rules, you have two options...

1) Dip into your savings for the extra $21,000, add it to the $84,000, and fully fund your Roth IRA conversion with $105,000

Or...

2) Send your check back to the plan administrator and request a direct transfer of funds to your Roth IRA account, then dip into your personal savings in order to pay your tax bill.

Of course, both of those options assume you have adequate personal savings to pay your conversion tax bill...

Paying Your Conversion Taxes

How you pay the taxes triggered by your conversion is a significant factor in determining whether or not it's a good idea to convert in the first place.

Why?

Because if you have to pay your tax bill with funds from your conversion, you lose twice...

• First, he amount you withdraw to pay taxes is subject to a 10% early withdrawal penalty, and...
• Second, whatever goes toward paying your tax bill does NOT go into your Roth IRA.

But if you pay your tax bill with funds from your personal savings, you won't have to worry about paying an early withdrawal penalty and all the funds from your conversion end up in your Roth IRA, where they grow tax-free for your benefit.

Need an example?

Let's say you have a 401k worth $100,000, and you're in the 25% tax bracket. You decide to convert your 401k to a Roth IRA, triggering a 25% income tax liability on the $100,000 conversion.

As a result, you owe Uncle Sam $25,000.

If you pay the $25,000 tax bill from your personal savings, you end up with $100,000 in your Roth IRA.

But what if you don't have $25,000 in savings?

If you need to use conversion funds to pay your $25,000 tax bill, then you end up with only $75,000 in your Roth IRA.

And the $25,000 withdrawn to pay your taxes? It's also subject to a 10% early withdrawal penalty.

So instead of having a $25,000 tax liability, you have a $27,500 tax liability. In such a case, you either need to come up with an extra $2,500 in savings or you need to withdraw more funds... which, of course, is subject to a 10% penalty as well!

Do you see how this can be costly to your retirement savings?

So, if at all possible, pay your Roth IRA conversion tax bill with funds from your personal savings.

Conclusion

In 2008, the Roth IRA conversion rules underwent some changes, and in 2010, the rules are set to change again.

Just focus on these key points you need to remember when performing a Roth IRA conversion...

• Have an open/established Roth IRA account to move funds into
• Make sure you move conversion funds into your account within 60 days
• Make sure you pay taxes on any Roth IRA conversion distributions (if necessary)

In addition to the above points, remember that (prior to 2010) you're ineligible to make a Roth IRA conversion if you have adjustable gross income (AGI) in excess of $100,000. However, once 2010 arrives, anyone can perform a conversion regardless of income.

Simply follow the rules, and you should have no problem completing the conversion process successfully!