The beginning of the year may be a good time to see if converting a traditional IRA to a Roth IRA makes sense for you. Read below to find out why, as well as to get answers to the questions we often hear from would-be converters.
Q. Does it matter when you convert?
A: There are potential benefits to converting either early or late in the year. That said, converting earlier generally gives you more flexibility than converting later. Consider the pros and cons.
Early in the year
- You may have up to 16 months to pay the taxes on your converted balances.
- Taxes aren’t due until April 15 of the following year. (Note: People who pay estimated taxes may need to make payments sooner.)
- If you change your mind, you have until October 15 to undo the conversion.
If you convert all your eligible balances and then undo the conversion within the same tax year, you’ll have to wait until January 1 of the following year before you can reconvert those balances back into a Roth IRA.
Later in the year
- The clock on the five-year rule for taking a distribution from a Roth IRA begins in January of the year you convert, no matter when you actually convert. So a conversion on December 31, 2012, is considered the same as a conversion made on January 1, 2012. Both would be eligible for penalty-free withdrawals beginning January 1, 2016. So if you convert later in the year, you have the potential to access these funds almost a full year sooner than if you converted earlier in the year.
- You’ll have more information about your income taxes for the year, which may allow you to convert a more targeted amount to ensure that the conversion doesn’t bump you into a higher tax bracket.
- Should you need to undo the conversion, you’d have the shortest reconversion waiting period (30 days).
Taxes on the amount you converted will be due not long after your conversion.
Q. Why would I want to consider undoing a conversion?
A: There are good reasons why you may want to undo a conversion, put the assets back into a traditional IRA (or other account), and get a refund of taxes paid:
- Your taxable income ended up higher than you expected and/or the additional income from the Roth IRA conversion bumped you into a higher federal income tax bracket.
- You’ve determined that your taxable income in retirement will likely be lower than you expected, reducing the potential benefits of a Roth IRA’s tax-free distributions.
- The value of your investments in the converted Roth IRA declined.
- You don’t have enough cash on hand to pay the taxes.
- Any other reason, really. The IRS has no requirements on this front.
The process of undoing a Roth IRA conversion, called “recharacterization,” needs to be completed by the last date to file or refile your prior-year taxes, including extensions. This is typically on or about October 15. For instance, a Roth IRA conversion made in 2011 needs to be recharacterized, and taxes refiled, by October 15, 2012. That’s why the earlier in the year you convert, the longer you have to get a clearer picture of your taxes and to determine whether a recharacterization makes sense. You can generally recharacterize all or a portion of what you converted. If you want, assets that you recharacterize to a traditional IRA can be reconverted back to a Roth IRA in the next tax year or 30 days after the recharacterization, whichever is later.
Q. Can I convert just part of my IRA balances to a Roth IRA?
A: Yes, you can choose to convert as much or as little as you want of your eligible balances in IRAs and/or workplace savings plans from former employers. This flexibility allows you to manage the tax cost of your conversion. For instance, since what you convert is generally considered taxable income, you may want to consider converting no more than what you think will bring you to the top of your current federal income tax bracket. You also may want to consider basing your conversion amount on the tax liability you may incur so you can pay it without using money from your conversion.
Q. How can I estimate my tax liability on a conversion?
A: Your tax liability is based on two things: the taxable income generated by the conversion and your applicable tax rate. To determine what portion of your conversion is taxable income, you need to know the types of contributions in your conversion-eligible IRA and workplace accounts. That’s because your contributions to these accounts could be either pretax (deductible) (e.g., no income taxes were paid on the contribution amount) or after tax (e.g., income taxes were paid when you made the contribution).
Estimating your taxable income can be straightforward if all your contributions in conversion-eligible accounts were pretax. In this case, whatever amount you convert will be taxable income.
It becomes a little tricky if you have after-tax contributions in your conversion-eligible accounts. It also depends on the type of non-Roth account you are converting from. Generally, the portion of your conversion representing pre-tax contributions and any earnings will generate taxable income for the year of conversion. Therefore, you’ll need to determine what portion of the conversion amount will be after-tax contributions and then subtract that amount from your proposed total conversion amount to estimate the taxable income portion. It’s a good idea to check with a tax adviser before you convert.
Here are some general guidelines for converting after-tax contributions:
After-tax (nondeductible) contributions in IRAs
Per IRS rules, you cannot “cherry pick” and convert just after-tax contributions (leaving pretax amounts in the account) in your eligible non-Roth IRAs so you won’t incur any taxes. Instead, you need to determine the percentage of after-tax contributions across all your IRAs and use that percentage to then determine the portion of the converted amount that will not be considered the taxable amount of your conversion. In order to calculate this percentage, you need to total both the balances and the after-tax amounts in all types of non-Roth IRAs in your name, even if they are held at different IRA providers. Don’t include your spouse’s IRAs or any inherited IRAs when doing this.
Consider this example. Let’s say you have $100,000 eligible for conversion in two IRAs. One account has $85,000 in pretax contributions and earnings; the second account has $10,000 in after-tax contributions and $5,000 in earnings (pretax), for a total of $15,000. You decide you want to convert $10,000 this year. The taxable income on the $10,000 conversion would be $9,000. Ninety percent ($90,000) of the total eligible IRA balance ($100,000) is in pretax contributions and earnings. So your taxable percentage is 90%. For the $10,000 conversion amount, that’s $9,000.
Tip: If you and your spouse both have conversion-eligible IRAs, you may want to compare the total percentage of pretax contributions and earnings on the total of each of your eligible IRA balances. Why? If your spouse has IRAs with mostly aftertax contributions and you have IRAs with mostly pretax contributions, you might consider converting your spouse’s IRAs before yours to reduce the potential tax impact of conversion.
For after-tax contributions in a workplace savings plan account:
Determining the taxable amount of a conversion from an eligible workplace savings plan with after-tax contributions is similar to that of an IRA. You need to determine what percentage of your account balance would generate taxable income. This is based only on the workplace savings plan account you are converting. Do not include any of your IRA balances or other workplace savings plan balances.
For example, let’s say you have $50,000 in after-tax contributions and $50,000 in pretax contributions and earnings, for a total of $100,000 in your 401(k) plan from your former employer, ABC. You also have $100,000 in a 401(k) plan from another former employer, XYZ, with only pre-tax contributions. Both account balances are eligible to be converted to a Roth IRA. The chart below illustrates your estimated taxable income.
Tip: In addition to converting balances in a workplace savings plan from a former employer to a Roth IRA, you have the option of rolling them into a traditional IRA. If there is a chance that you may want to convert this money to a Roth IRA at some point, and either your existing IRAs or the workplace balances include after-tax contributions, consider this before rolling over those plan assets to a traditional IRA. Once these balances are in an IRA, they have to be included along with your other IRA balances (non-Roth) in determining what portion of your conversion generates taxable income. This could potentially increase the portion that may need to be recognized as taxable income. It’s important to consult a tax adviser when considering a conversion of after-tax assets.
Q. Do I still need to take an MRD in the year I convert?
A: Yes. People age 70½ and older are generally required to take a minimum required distribution (MRD) every year from their tax-deferred retirement accounts (traditional, SEP, rollover, SIMPLE IRAs, and workplace plan accounts). MRD amounts are not eligible to be converted to a Roth IRA.
IRS rules specify you must satisfy the MRD for the year of conversion before initiating a Roth IRA conversion. Converting the MRD amount can result in an excess contribution to the Roth IRA and can trigger possible excise taxes. You can satisfy your MRD amount from any one or more of your non-Roth IRAs (other than an inherited IRA).
Say, for example, you have a $100,000 traditional IRA with a $7,000 MRD for 2012. If you were to convert the entire $100,000 balance to a Roth IRA this year, you’d want to satisfy the MRD first. If you don’t, the $7,000 MRD amount would be considered an annual contribution to the Roth IRA, not a conversion. (In this example, you’d effectively be making a $93,000 conversion and a $7,000 Roth IRA contribution.)
If you were not eligible to make an annual Roth IRA contribution because your income was too high or because the MRD amount of $7,000 was above the annual Roth IRA contribution limit of $5,000 ($6,000 for those age 50 or older), the $7,000 may be subject to IRS excess contribution penalties, including excise taxes of 6% annually on some or all of the $7,000 contribution until the excess contribution is corrected.
To avoid this situation, take your MRD from your traditional IRA(s) (other than an inherited IRA) before converting. If you have already done a conversion in 2012 but didn’t take the MRD, you should speak to your tax adviser.
Q. How does my state tax Roth IRA conversions?
A: A Roth IRA conversion is a taxable event. If your state has an income tax, it will likely be treated as taxable income by your state, as well as for federal income tax purposes. (Currently, applicable state tax laws appear to conform to the IRS eligibility rules for Roth IRA conversions.) Because each state’s income tax rules can be different, however, it makes sense to check with a tax adviser before you convert.
Q. I have both pretax and after-tax money in my 401(k). I heard that it’s possible to directly roll over all of the pretax contributions and earnings to a traditional IRA and directly roll over and convert all of the after-tax contributions to a Roth IRA, avoiding taxes on the converted amount. Is this accurate?
A: Unfortunately, the IRS hasn’t specifically addressed the income tax implications of this approach. Ultimately, you are responsible for reporting any taxable income resulting from a Roth conversion. The IRS recently issued workplace savings plan guidance indicating that any direct rollovers of a portion of a plan distribution must include an allocable portion of after-tax contributions, if there are any. This guidance indicates that the IRS could conclude that the portion of the plan distribution directly converted to a Roth IRA must include a proportional allocation of both pretax and after-tax plan contributions (if the plan held both). Such an IRS interpretation would result in taxable income under this approach. We suggest you work with a tax adviser if you are thinking about doing this.
We believe that because of the tax-free growth potential and withdrawals, most investors should consider having a Roth IRA as part of their overall retirement plan. But deciding whether to convert isn’t necessarily a straightforward decision. That’s why we suggest you carefully assess your situation and check with a tax adviser to help you make an informed decision.
- Learn more about converting to a Roth IRA.