Convert an IRA to a Roth IRA – What You Need to Know

Understanding the rules and benefits of converting an IRA to a Roth IRA will help you know income limits, conversions rules and if there is a better time of year to convert. The following answer, courtesy of www.newsobserver.com, will explain in detail…

Since 2010, anyone can convert an IRA to a Roth IRA. You will owe income tax on the amount converted and it is best if you have money to pay this tax available in a non-retirement account. In general, a conversion usually makes sense if you think you will be in the same or a higher tax bracket in the future. The more years you have before you will need to use the money you are converting, the more a conversion makes sense. The benefit of the long-term tax-free compounding is lost if you tap into the converted IRA relatively soon after the conversion. Roth IRA conversions are subject to a five-year rule. Each conversion must meet the five-year rule for distributions to be penalty-free. Distributions of the converted amounts five years after the conversion or when the account holder attains age 591/2, whichever occurs sooner, are penalty free. Roth conversions have a Jan. 1 starting date for the five-year rule regardless of when in the year the conversion occurs. If you convert an IRA in December of this year, your five-year period will be met Jan. 1, 2018. Converted amounts are always tax-free and penalty-free if you are 591/2 or older, or meet the five-year test. Distributions of earnings must meet the five- year test to avoid taxes even if you are 591/2 and will be subject to tax if you’re younger than 591/2.

The IRS considers withdrawals from a Roth IRA first as a return of contributions (tax- and penalty-free), which you don’t have with a conversion IRA, then as a return of converted amounts (tax- and penalty-free if you meet the five-year rule or you are at least 591/2), then any money taken out is considered earnings.

For a conversion to count as a 2013 Roth conversion, the funds must be withdrawn from the traditional IRA by Dec. 31, 2013, and must be deposited in the Roth IRA within 60 days. The simplest way to make your Roth IRA conversion is via a direct roll-over or trustee-to-trustee transfer with the current IRA custodian.

You can re-characterize a Roth IRA. The term re-characterization applies when a taxpayer converts a traditional IRA to a Roth IRA and then decides to change it back or “re-characterize” it to a traditional IRA. You have until the due date of your 2013 tax return to re-characterize your 2013 conversion (Oct. 15, 2014, with extensions). Meet with a financial or tax adviser for further details and concerns on your personal situation.

 

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