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Making Sense of Roth IRA Conversions

12.01.14

As we near the end of the year, there are a number of tax planning opportunities to consider. The Roth IRA conversion is one such opportunity. If you have retirement funds saved in a traditional IRA, SEP, or SIMPLE, you can convert part or all the funds to a Roth IRA. You will pay income tax now, but it may ultimately benefit you in the future.

Cost

You pay income tax on the amount converted, less non-deductible contributions. It is usually more efficient and effective to pay the tax from funds outside your retirement accounts. Depending on your circumstances, you may be subject to additional taxes when using money from a retirement account to pay the tax. You can estimate the tax cost based upon your marginal tax rate. We can provide a more accurate estimate by doing tax planning. This will help you understand the implications of what you are considering so you can make an informed decision.

Benefits

  • Investments held in a Roth IRA grow tax free.
  • Distributions from Roth IRAs are tax free if you meet certain requirements.
  • Roth IRAs are not subject to the minimum distribution requirements that apply to traditional IRAs.
  • There are some additional estate tax benefits to consider if you expect to have a taxable estate.

Second Thoughts

If you decide the Roth Conversion was a mistake, it can be reversed through a process called a recharacterization. The amount converted, plus earnings, is put back into a Traditional IRA and it is treated as if the conversion never happened. The reversal must be done by October 15th of the year following the conversion. Recharacterization should be considered if there is a substantial drop in the value of the assets from the conversion prior to the deadline for reversal. There are strategies to increase the benefit of recharacterization that involve doing multiple conversions in a year and holding different investments in each account. The accounts with investments that decrease in value are good candidates for recharacterization.

When To Consider A Roth Conversion

  • You expect to be in a higher tax bracket in retirement.
  • Your income is atypically low in one year.

Timing And Other Issues

  • The conversion is taxable in the year the funds are transferred. Make sure to initiate by December 31st.
  • There are complications with a recharacterization when the converted funds have been comingled with other Roth IRA funds. Keep the funds separate until the recharacterization period expires to avoid these issues.
  • The law that prevented high-income taxpayers from doing conversions was repealed. Taxpayers are now eligible to do conversions regardless of income level.