What is a Roth conversion?

A conversion is a taxable, reportable movement of assets from either a Traditional IRA (including Traditional IRAs that hold SEP contributions) or a SIMPLE IRA (after a two-year period) to a Roth IRA.

When converting assets to a Roth IRA, the IRA owner must pay tax on all converted pretax assets in the year the assets leave the Traditional IRA or SIMPLE IRA. Although the assets are taxed, properly converted assets are not subject to the 10 percent early distribution penalty tax.

How do you convert assets from a Traditional IRA to a Roth IRA?

A conversion can occur either as a direct conversion or an indirect conversion.

• With a direct conversion, there is no time limit because the IRA owner does not have constructive receipt of the assets.

• With an indirect conversion, the IRA owner has constructive receipt of the assets and must redeposit the assets into a Roth IRA within 60 days after receiving the assets. The one-per-12-month rule that applies to rollovers does not apply conversions.

Who should consider converting to a Roth IRA?

• Young Traditional IRA owners with smaller balances

• Individuals who need flexible access to their IRA assets (college education, new home, or any other expense)

• Individuals with a large amount of nondeductible assets

• Individuals concerned about future tax rates at retirement

• Individuals who want to avoid taking RMDs

• Individuals who wish to give their beneficiaries tax-free assets

Can IRA owners convert their required minimum distribution (RMD)?

In any year for which a Traditional or SIMPLE IRA owner is required to take an RMD, she must use the first assets distributed to satisfy that year’s RMD. An IRA owner may not convert RMD amounts. Only after the individual satisfies the RMD for the year may she convert her Traditional or SIMPLE IRA assets to a Roth IRA.

I heard someone say that an individual could still make a Roth contribution even if that individual’s income is too high to make a regular contribution?

Individuals whose modified adjusted gross income (MAGI) exceeds the Roth IRA income limits are not eligible to make regular Roth IRA contributions. The “Roth IRA loophole”, sometimes referred to as the “backdoor Roth”, allows individuals who do not qualify to contribute to a Roth IRA to make a nondeductible Traditional IRA contribution, and then immediately convert the assets to a Roth IRA.

• If the individual contributes to a new Traditional IRA, and has no other Traditional or SIMPLE IRAs, the conversion is generally tax-free.

• If the individual has existing Traditional or SIMPLE IRAs, a portion of the conversion is generally taxable. The IRA owner must use the pro rata calculation found in IRS Publication 590-B, Distributions from Individual Retirement Arrangements (IRAs), to determine the taxable portion of the conversion.

What other factors should individuals consider before converting assets from a Traditional IRA to a Roth IRA?

The financial organization holding the distributing Traditional or SIMPLE IRA must apply withholding rules to all conversions (i.e., direct and indirect). The effect of withholding is different depending on whether the IRA owner is under age 59½ or age 59½ or older.

If an IRA owner is under age 59½ and elects to withhold on a distribution that is converted, the amount withheld is not converted to the Roth IRA and is subject to the 10 percent early distribution penalty tax (unless another penalty tax exception applies).

Do IRA owners need to convert their entire Traditional IRA balance?

No—individuals are not required to convert their entire Traditional or SIMPLE IRA balance. An IRA owner may convert all or a portion of the Traditional or SIMPLE IRA. Because of the tax implications, IRA owners should talk to a competent tax advisor for questions regarding the taxation of their conversions.