By Myra O’Dell of BCS Wealth Management and Sarah Presnell of Blackburn, Childers & Steagall
If you have your retirement savings in a traditional IRA, you are allowed to convert some or all of your funds to a Roth IRA. Prior to 2010, individuals were not allowed to convert to a Roth IRA if their income exceeded $100,000. Before deciding if you should convert your plan to a Roth IRA, there are certain considerations such as the tax cost of converting, whether or not the conversion will help you save money and how much, if any, you should convert.
Traditional IRAs v. Roth IRAs
First, let’s discuss the differences between a Traditional IRA and a Roth IRA. Unlike Traditional IRAs, Roth IRA contributions are not deductible on your individual tax return. However, withdrawals of contributions are always tax-free and withdrawals of earnings are tax-free as long as it has been at least five years since the year of your first Roth IRA contribution and at least one of the following conditions have been met: you reach age 59 1/2, pass away, become disabled or make a qualified first-time home purchase, up to a $10,000 lifetime limit. In addition, the owner of a Roth IRA can make contributions after age 70 1/2 and required minimum distributions are not mandatory during the account owner’s lifetime.
Figuring Reportable Income from a Traditional IRA
One step you should take when deciding to convert to a Roth IRA is to figure out the income you will have to report as a result of the conversion. For deductible IRA funds, the income that will be reported is the value of the funds on the day you convert.
It is important to note that income reported from a Roth conversion may be offset by various deductions with proper planning in order to avoid significantly increasing your taxable income. For example, if you have to report $5,000 in income from a Roth conversion, you may be able to offset this income from additional charitable contributions, etc.
Special Rules for Converting Nondeductible IRAs
Nondeductible IRAs are IRAs in which your contributions were not tax-deductible on your individual tax return in the year that you made the contribution. If you have both a deductible IRA and a nondeductible IRA, a pro-rata rule must be applied to determine the taxable income. Specifically, the amount of all nondeductible IRA contributions must be divided by the total value of all individual IRAs (including SEP IRAs and SIMPLE IRAs). This ratio is then multiplied by the dollar amount being converted to find the amount of the conversion that will not be taxed. In other words, account holders cannot simply convert the nondeductible contributions and pay no income tax.
Calculating the Tax
After figuring the amount of income you will have to report, the next step is to calculate the tax. Because Roth conversions can increase taxable income, the increase in income could propel you into a higher tax bracket, trigger a phase out or elimination of various deductions or tax credits, result in less of your itemized deductions being utilized, increase your alternative minimum tax or may subject more social security benefits to tax.
Determining If You Should Convert
Now that you know how to calculate the tax consequences, the question in determining whether or not you should convert to a Roth mainly depends on if you are better off paying tax on your savings now or waiting until you withdraw money from your account. Your answer will depend partly on whether you think your marginal income tax rate will be higher or lower in retirement than it is now. As an added complication, no one can predict with certainty what tax rates will be in the future. Another factor to consider is whether you can afford to pay the taxes currently. It is best to pay the tax due with money outside of the converted assets because money used to pay the tax from within the IRA will count as a distribution and may cause early withdrawal penalties.
Items to Remember About Converting
If you do decide that a Roth conversion is best for you, here are some things to keep in mind:
- The deadline to convert to a Roth IRA is December 31st.
- Contributory Roth IRAs and Roth conversion IRA funds may be combined into the same Roth IRA account.
- Beginning in 2010, all investors may convert a traditional, SIMPLE, SEP or SAR SEP IRA to a Roth IRA regardless of income or tax filing status. A SIMPLE IRA must be open for two years before it can be converted.
- There is good news for participants in 401(k), 403(b), or 457(b) retirement plans due to the American Taxpayer Relief Act of 2012. These plans may now allow all participants to convert amounts in their pre-tax accounts to Roth accounts within the plan. Prior to 2013, only those participants who were eligible for a distribution were allowed to do a Roth conversion.
- The converted assets must remain in the Roth IRA account for the five year holding period. If the assets are distributed before the five year holding period, then the distribution may be subject to penalties.
If you do a Roth conversion and later realize that the tax liability of a Roth conversion is not advantageous to your overall tax situation, you may reverse the conversion, which is called a recharacterization. To recharacterize a Roth conversion, you must transfer the assets plus any net earnings attributed to those assets into another non-Roth tax-deferred retirement account. The deadline to recharacterize is your tax-filing deadline plus extensions. When recharacterizing a Roth Conversion to a Traditional IRA, you may not “reconvert” those assetsback to a Roth IRA before the later of:
- The year following the taxable year in which the account was first converted to a Roth IRA, or
- The end of the 30-day period beginning in which you recharacterize the conversion amount back to the original IRA.
Converting to a Roth IRA is a big decision that can be made easier by contacting us for any questions. Together, BCS and BCS Wealth Management can provide the expertise to help you determine the best plan of action for your specific needs.