Converting a Traditional IRA to a Roth IRA
The case for converting, and how to do it

As a greater segment of the popula...
Will your tax rate go up or down                                Will overall tax rates go up or down in the future?
in ret...
exAMPLe 1


  •Investor owns a non-deductible IRA, valued at $20,000
  •The non-deductible IRA includes $10,...
Make sure you act by the end of the year                        Potential tax implications of reconversions
Finally, if yo...
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Roth IRA Conversion


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Roth IRA Conversion

  1. 1. Converting a Traditional IRA to a Roth IRA The case for converting, and how to do it As a greater segment of the population enters Additionally, beginning in 2008, participants in qualified retirement, investors increasingly are looking for retirement plans like 401(k)s have the option of a direct tax-free sources of income. Congress established rollover from the plan to a Roth IRA. Previously, the Roth IRA in 1998 as one such source of tax-free participants were required to roll over balances to a income. Although investors could not deduct Traditional IRA and then subsequently convert to a contributions, their accounts grew tax free, and they Roth IRA. The same rules currently governing Roth were not required to take withdrawals after age 701/2. IRA conversions will apply to direct rollovers from a retirement plan to a Roth. However, investors cannot contribute to a Roth IRA unless they earn $120,000 or less per year ($176,000 The case for converting or less for married couples filing jointly, based on 2009 The fact that Roth IRAs offer tax-free withdrawals contributions). Congress has recently taken steps to is appealing to retirees looking to generate income in begin to broaden that availability, prompting many inves- retirement. Furthermore, the Roth IRA will appeal to tors in Traditional IRAs to wonder whether they should more affluent individuals looking to maximize the legacy convert their IRAs to a Roth. What follows is a review of they leave to their beneficiaries since, unlike Traditional the rules governing Roth conversions and a discussion IRAs and other tax-deferred retirement plans, minimum of the pros and cons of converting. distributions are not required during the account owner’s lifetime. As an additional benefit, beneficiaries receive New rules on Roth conversions these IRA proceeds free of income taxes. The Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA), enacted in May 2006, changes the rules Also, if you believe you will be in a higher tax bracket in governing conversions of Traditional IRAs into Roth IRAs. retirement, it may make sense to incur the tax liability Starting in 2010, Roth IRA conversions will be available to now in exchange for federal tax-free growth and tax-free all taxpayers regardless of income. Currently and through distributions later. Moreover, the one-time opportunity 2009, taxpayers with more than $100,000 in modified TIPRA allows in 2010 of spreading the tax burden over adjusted gross income (MAGI) are ineligible for conversion two years may be beneficial. (note that MAGI excludes the amount included in gross An important consideration in deciding to convert a income resulting from the conversion and certain other Traditional IRA to a Roth IRA, however, is that the entire items of income). balance of the Traditional IRA may be immediately Conversions from a Traditional IRA to a Roth IRA are taxable at ordinary income rates. Taxes should be paid treated as taxable distributions. However, under the new from funds other than the Traditional IRA distribution to law, taxpayers who convert in 2010 can elect to pay the maximize the benefit of converting. Also, if you believe federal income tax due in two equal installments over the you will be in a lower tax bracket in retirement, it may following two years. make sense to forgo converting.
  2. 2. Will your tax rate go up or down Will overall tax rates go up or down in the future? in retirement? Federal tax rates are at historically low levels. In fact, over Predicting what your taxes will be 10 or 20 years from the past 80 years tax rates have only been at this level or now is an uncertain — if not impossible — task. However, lower 14% of the time.* Given the large federal deficit and there are a variety of factors that can help you determine projected Social Security shortfalls, it may be appropriate in what direction your personal tax status might be to hedge against potential future tax rate increases. headed in the future. Will you need access to the funds before retirement? YOuR TAxeS MAY gO DOWN If: The Roth IRA offers unique flexibility for individuals considering a withdrawal from their IRA before •You expect to stop working (or only work part-time) and, retirement. If you convert to a Roth IRA and own therefore, would earn less and be in a lower tax bracket it for at least five years, you can opt to withdraw the •You plan to move to a state that has lower, or no, state conversion amount without taxes or penalty. income taxes Is tax-free income in retirement appealing? •You plan on moving to a larger home, increasing the Just as it makes sense to diversify savings across different amount of deductible interest you can claim asset classes, allocating income sources between taxable •You expect to have significant deductible and tax-free vehicles may be a good idea. Therefore, health-care expenses it may be prudent to consider converting a portion of YOuR TAxeS MAY gO UP If: Traditional IRA assets to a Roth IRA to create a source of tax-free income in retirement. •You plan to pay off your mortgage or move to a smaller home, therefore decreasing the amount of deductible Figuring taxes on a conversion interest you can claim As a reminder, converting a Traditional IRA to a Roth IRA •You are claiming dependents now that you won’t be is a taxable event. Let’s assume a typical example where able to claim in retirement an investor owns a Traditional IRA consisting entirely of •You expect to receive significant income from large pretax contributions and earnings. In this case, the entire lump-sum retirement plan payments, IRAs, or annuities amount converted from the Traditional IRA to a Roth •You plan to liquidate taxable investment savings IRA would be taxable as ordinary income for the year in or other assets which the conversion occurred. Paying the taxes due on a •You plan to move to a state with higher income taxes Roth IRA conversion is the trade-off for receiving tax-free income in retirement. How are non-deductible IRA contributions taxed on Additional factors a Roth IRA conversion? It is important to note that an individual’s tax situation In some cases an investor may hold “after-tax” funds in is not the only factor driving the decision of whether to his or her IRA. This might include contributions to a non- convert IRA funds to a Roth IRA. Here are some other deductible IRA, for example. Since the non-deductible key considerations for investors: contributions were previously taxed, only subsequent Do you plan on leaving a legacy to the next generation? earnings would be taxable on a conversion to a Roth IRA. Since there are no required minimum distributions during the account owner’s lifetime, the Roth IRA allows you to maximize the amount you pass along to future generations. Additionally, unlike Traditional IRAs and retirement plans, your beneficiaries won’t have to pay income taxes when they take distributions out of the Roth IRA. *Source: Internal Revenue Service, March 2006.
  3. 3. exAMPLe 1 ASSuMPTIONS •Investor owns a non-deductible IRA, valued at $20,000 •The non-deductible IRA includes $10,000 in after-tax contributions and $10,000 in earnings •The investor does not own any other IRAs (including a SEP IRA or a SIMPLE IRA) •The investor would like to convert the $20,000 non-deductible IRA to a Roth IRA ReSuLTS •$10,000 in after-tax contributions are not taxed •$10,000 in earnings are taxable at ordinary income tax rates at the point of conversion However, if the investor does own other IRAs, figuring the taxes due upon converting to a Roth IRA becomes more complex. For the purpose of calculating the taxes at conversion, ALL IRA accounts must be considered in aggregate. To figure the taxes due, you need to determine which IRA assets have been previously taxed. Here’s how it works: exAMPLe 2 ASSuMPTIONS •Investor also owns a Rollover IRA valued at $80,000, which consists of contributions and earnings that have never been taxed •The investor would like to convert just the $20,000 non-deductible IRA in the example above to a Roth IRA STeP 1 STeP 2 STeP 3 Add all IRA accounts together Determine the proportion of Apply this proportion to the amount of Traditional IRA $20,000 non-deductible IRA + non-deductible (i.e., “after-tax”) assets being converted to a Roth IRA to calculate the $80,000 Rollover IRA = IRA contributions to the total amount not taxable at the point of conversion $100,000 IRA assets $20,000 non-deductible IRA x 10% = $2,000, which will be in total IRA assets $10,000 non-deductible IRA non-taxable at the conversion to a Roth IRA; the remaining contributions ÷ $100,000 $18,000 would be taxed as ordinary income. total IRA assets = 10% The $8,000 of non-deductible contributions that are not treated as distributed are allocated to the Rollover IRA. That is, following the conversion, the Rollover IRA will be treated as holding $8,000 of non-deductible contributions. Important considerations before A partial conversion can reduce your tax bill converting to a Roth IRA If you find that converting your entire Traditional IRA to Don’t convert to a Roth IRA unless you have other a Roth IRA creates too large a tax burden, you may want funds available to pay the taxes to consider a partial conversion. A partial conversion Taxes on the pretax funds and earnings will be due in may allow you to avoid being pushed into a higher tax the same year in which the conversion takes place. You bracket by the amount of taxable income that would should have funds available outside of a retirement plan be generated in a full conversion. Taxpayers need to to pay these taxes. Otherwise, you will likely be forced to consider the effects of additional income generated use some of the assets in the Traditional IRA to pay the from converting IRA assets to a Roth IRA. For example, taxes, which could trigger an early withdrawal penalty an increase in Adjusted Gross Income (AGI) may: on those assets and create an even greater tax burden, • Cause Social Security benefits to be taxable as well as decrease the amount eligible for tax-favored accumulation over time. • Negatively impact itemized deductions like medical expenses • Result in phase-outs for deductions or personal exemptions • Disallow certain tax credits
  4. 4. Make sure you act by the end of the year Potential tax implications of reconversions Finally, if you decide that converting to a Roth IRA is If you convert an amount from a Traditional IRA to a Roth the right choice, you must convert by December 31 of IRA and then transfer that amount back to a Traditional the current year to realize any income as a result of the IRA in a recharacterization in the same year, you may conversion within that tax year. There may be a benefit to not reconvert that amount from a Traditional IRA to a realizing the additional income in one year rather than in Roth IRA during the same tax year or, if later, during future years. Investors then have until the date their tax the 30-day period following a recharacterization. If you return is due to change their mind and undo the conver- reconvert during either of these periods, it will result in a sion without paying any taxes or penalties. failed conversion, which would subject you to additional tax penalties. To avoid a failed conversion, you must Roth IRA recharacterization move the amount converted, including all earnings from Roth IRA recharacterization is a rule that essentially the date of the conversion, into a Traditional IRA by the allows you to undo a conversion from a Traditional IRA due date for your tax return for the year during which to a Roth IRA. You have until the maximum extension you made the conversion to the Roth IRA. You should of the tax filing deadline (October 15) to reverse the consult a tax professional prior to a recharacterization or transaction and place the assets back into the Traditional a reconversion in order to avoid any potential tax implica- IRA as if the conversion had never taken place. tions or a failed conversion. Possible applications Your financial representative can help • Failure to qualify for a Roth IRA conversion Converting some or all of your IRA balances to a Roth IRA may yield significant benefits down the road. • You decide that you don’t want to pay income taxes as a However, there are many considerations that should go result of the Roth IRA conversion into such a decision, and the best way to find out how • The IRA decreases in value as a result of market losses. such a decision may affect you is to talk to your financial If the value of the IRA account decreases after a Roth representative. He or she can discuss your specific situ- conversion due to market activity, you might consider ation, as well as recent changes in the tax law, and how a recharacterization. This strategy can help you avoid you can take advantage of them as you prepare for a reporting income on your tax return (as a result of the secure financial future. conversion) that exceeds the actual account value. This information is not meant as tax or legal advice. You should consult with the appropriate tax or legal professional before making any investment decisions. Putnam Retail Management Putnam Investments | One Post Office Square | Boston, MA 02109 | IR757 257828 8/09