Converting an IRA to a Roth IRA
When you withdraw funds from an IRA, distributions are taxable as ordinary income. But would you prefer to pay taxes now so you don’t have to pay taxes on distributions in your retirement years? If so, consider converting part or all of your IRA to a Roth IRA. The following are a few reasons why people convert – or choose not to convert – their IRAs.
Reasons to Convert to a Roth IRA
- You don’t plan to withdraw your funds for a number of years.
- You have money available to pay taxes on the conversion.
- You think that your ordinary income tax rate may be higher in retirement than it is today.
- You prefer not to take Required Minimum Distributions (RMDs) each year after turning 70½.
- You would like to take tax-free withdrawals in retirement.
- In the event of your death, you would like to provide a tax-free inheritance to your loved ones.
Reasons Not to Convert to a Roth IRA
- You plan to withdraw your funds within a few years or so.
- You can’t afford to pay taxes on the conversion now.
- You think that your ordinary income tax rate may be lower in retirement than it is today.
- You won’t mind taking Required Minimum Distributions (RMDs) each year after turning 70½.
- You suspect the government may change how Roth IRAs are taxed in the future.
Roth IRA Restrictions
Roth IRA Conversion Tax Consequences
- The amount of the Roth IRA conversion is taxable and is treated as ordinary income.
- The 10% early distribution penalty tax does not apply.
- If you made non-deductible IRA contributions and have more than one IRA, you must aggregate all of your IRAs (e.g. Traditional, Rollover, SEP and SIMPLE) to calculate the taxable portion of your distribution. In other words, the IRS views you as having one big IRA, regardless of how many IRAs you own.
Many years ago, Jenny made a $2,000 non-deductible contribution to an IRA. Her other contributions were deductible. Today, she has three IRAs that total $10,000.
Jenny converts $1,000 to a Roth IRA. Since her non-deductible contribution makes up 20% of her total IRA balance ($2,000 divided by $10,000), 20% of her $1,000 conversion (i.e. $200) is not taxable regardless of which IRA is converted.
NOTE: This is a simplified example. Be sure to complete and attach IRS Form 8606 with your taxes.
Roth IRA Recharacterization and Reconversion
- Reversing a Roth IRA conversion is called a recharacterization. You may recharacterize a Roth IRA conversion back to a Traditional IRA for any reason. You may choose to do so because you realize now that you do not have sufficient funds to pay the taxes – or simply don’t want to pay the taxes – due on your Roth IRA conversion.
- You may recharacterize part or all of a Roth IRA conversion up until October 15th of the year following the year of the conversion.
- After recharacterizing your Roth IRA, you cannot reconvert your IRA again until the later of:
- January 1st of the year following the year that the conversion took place or
- 30 days following the recharacterization back to the Traditional IRA
In March, Joe converts his $10,000 Traditional IRA to a Roth IRA. In November, his Roth IRA has fallen in value to $8,000. Hoping to save money on taxes, Joe recharacterizes his $8,000 Roth IRA back to a Traditional IRA. Because he reverses (“recharacterizes”) the conversion, he will not owe taxes on the conversion. However, Joe must wait until January 1st to convert his Traditional IRA again.
Download a Roth IRA Conversion Request Form