Is there a way to convert without paying taxes? It's almost impossible. Low-income seniors whose standard deduction and exemptions (a maximum of $22,400 in 2013 for a couple both age 65 or older) exceed their taxable income can convert the difference tax free. "Figure out how much in wasted deductions you have, and then convert that amount to a Roth," Piershale suggests.
Part of a conversion can be tax free if you have made nondeductible contributions to your traditional IRA. But there's a catch: You can't simply move that after-tax money to a Roth tax free. Instead, you must determine the ratio of after-tax contributions to the total balance in all your traditional IRAs, including tax-deductible contributions and earnings. Say you have made $10,000 in nondeductible contributions to IRAs that hold a total of $100,000. If you convert $10,000 to a Roth, only 10 percent of the conversion will be tax free.
Can I convert my required minimum distribution from my traditional IRA? No. Required payouts cannot be converted to a Roth. In fact, once you reach age 70 1/2, the first money out of a traditional IRA each year is considered your required distribution. Only after you have satisfied the payout requirement can you convert remaining assets to a Roth. The RMD is taxable, of course, and can be used to pay the tax on a Roth conversion.
How long do I have to wait to take tax-free withdrawals from my Roth IRA? There are different rules for contributed money, converted money and earnings. Because you must pay tax on contributions going into a Roth IRA, those direct contributions can be withdrawn at any age and at any time free of taxes or penalties.
To tap earnings tax- and penalty-free, you need to meet two conditions: You must be older than 59 1/2, and you must have had at least one Roth IRA for at least five years.
If you have never opened a Roth IRA, there's a good reason to create one—via contribution or conversion—before the end of the year. The clock on the five-year holding period starts ticking on January 1 of the year you opened the account. If you are, say, 58 now and you convert an IRA to open your first Roth in December 2013, you can begin to tap Roth earnings tax free in January 2018. Wait until January, and you will have to wait until 2019 to withdraw earnings tax free.
There is a separate five-year test for converted money. Taxpayers age 59 1/2 or younger must wait five years before they can withdraw a converted amount free of the 10 percent penalty. Each conversion has its own five-year period for this purpose. (The goal is to prevent the use of a Roth conversion as an end-run around the 10 percent early-withdrawal penalty for pre-59 1/2 payouts from traditional IRAs.)
Once you turn 59 1/2, that 10 percent penalty disappears. So the 58-year-old in the above example only needs to wait a year and a half to dip into the converted amount penalty free, though he must still wait the rest of the five years for withdrawn earnings to be tax free.
Account holders who want to tap Roths usually don't need to worry about withdrawing earnings too soon. Under IRS order-of-withdrawal rules, the money you take from a Roth is first considered to come from direct contributions, then converted amounts, and only after both have been depleted, earnings.
Can my heirs benefit from my Roth IRA? Estate planning is one of the major reasons that older taxpayers consider Roth conversions, especially for those who don't expect to ever spend the money. If you leave the Roth to a child or grandchild, all the money in the Roth goes to the heir free of income taxes and the account can be stretched over the heir's own life expectancy. "When grandkids inherit a Roth IRA, they will have tax-free growth for the rest of their lives," says Moraif. It is "one of the best financial gifts you can give to a young person." (The Roth is still included in your estate for estate-tax purposes.)
Nonspouse heirs are required to take minimum distributions from inherited Roth IRAs starting the year following the owner's death. However, if the Roth was your first Roth and you die before you've met the five-year holding period, earnings won't be tax free for heirs until that test is met.
A surviving spouse can choose to remain a beneficiary of the account or can take the Roth as his or her own. A spouse who does the latter would not be required to take minimum distributions.
Using a Roth conversion as an estate-planning tool has another benefit for wealthy taxpayers. "You're reducing the size of your taxable estate when you pay conversion taxes," says Fahlund.
If you plan to leave your IRA to charity, do not convert the account. The charity would owe no taxes on the traditional IRA, so by converting it you would be paying Uncle Sam unnecessarily.
Will I owe state income tax if I convert? Yes, unless you live in one of the nine states that does not tax ordinary income. If you plan to move in retirement, consider how your new state's income tax rate stacks up to the tax rate in your current state. If you are moving from a state that taxes income, such as Connecticut, to a state that doesn't, such as Florida, wait to convert until after you move.
What if I decide the IRA conversion was a mistake? "There is the undo button if it turns out the conversion strategy didn't pan out as expected, or you don't have cash to pay the tax bill," says Fidelity's Hevert. You can undo a Roth IRA conversion—known as a recharacterization—up until October 15 of the following year.
Recharacterizing is a good idea if the account value has dropped since you converted. If you converted $50,000 in 2013, but the account value later drops to $35,000, you will still owe tax on the $50,000. Reverse the conversion by October 15, 2014, and you will wipe away the tax bill. "It's as if nothing ever happened in the first place," says Jacobs.
Even if the account value doesn't drop, you may want to undo the Roth IRA conversion if you can no longer afford the tax bill on the conversion. Or you might want to reverse it if the conversion ends up pushing you into a higher tax bracket than you thought you would be in.
Consider splitting your conversion into multiple Roth IRAs divided by asset class. That way, you can reverse the conversion only on accounts that have lost value. Say you split your Roth conversion into two: One Roth holds stocks, and the other holds bonds. If your bond Roth loses value but your stock Roth gains value, you can leave the stock Roth alone and just recharacterize the bond Roth.
Be aware that if you convert a 401k to a Roth 401k, you cannot undo it. However, you could convert that 401k money into a Roth IRA—that will allow you the option to recharacterize that money into a traditional IRA.
More from Kiplinger's Personal Finance magazine:
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The numbers are simple, the Roth is almost always better then the Traditional IRA.
It is interesting how people can get caught up in a smoke screen with the Roth Ira.
Is there any mathematicians that have done the computations on a Roth versus
a Traditional Ira?? I have, and if you compare APPLES to APPLES, numbers will
show the Roth is a poor investment. You will have more money in your pocket
through retirement with a Traditional Ira if you compare the Roth versus
Traditional on a APPLES to APPLES basis.
Writer missed the one piece of info I was looking for: what is the max contribution for a person under 50? For a Roth IRA not a Roth 401k.
What happens if a National Sales tax or consumption tax replaces our income tax? Remember Herman Cain's much-loved 9-9-9 Plan?
It won't matter where the money came from. You'll pay your new income tax as you spend every dollar, from whatever source.
My Roth just got taxed again when I spend it. Are you willing to wait 30-40 years to see if that happens?
You say you'll get some relief? How? On your tax return that just went away? Watch that back-door ploy that only a few will recognize.
First rule in tax planning....take the deduction now while it's still around.
In other words, max out the traditional 401K/IRA first, then contribute more to the Roth (to at the least start the 5 years rolling).
ROTH: If you didn't like the first set of public pension lies, the new lies are even simpler.
Any retirement plan that doesn't have your name on it is somebody else's retirement plan. Trusting your money to strangers is stupid. Sooner or later, the people managing your money are going to consider your money their money.
Your retirement should be held way outside the boundaries of "gamblers" and "investors" but it never is. ROTH is just another gimmick, another cheap shell game.
Risk should not even be a factor to private pensions and retirement accounts. The crash of 07-09 was not a "non-event" for people who were within 5-years of, or already retired. The crash of 07-09 meant that even if the markets ever got back to the pre-crash level of 14,000 that it would take them 15-years to make their money back. I saw too many older people doing the 1,000-yard stare, wondering what was going to happen to them.
When you are paying for your old age retirement yourself, as most people are, the subject of your money and your pension should not even be mentioned in the same breath as "professional gamblers."
This kind of thinking is killing this country and destroying its economy and tearing the fabric of polite society. As far as greed and avarice is concerned, enough is never enough. The whole subject of retirement plans is a huge lie. There needs to be some parts of people's lives that are separate from "the game that always remains the same," some part of their lives that is inviolate. There isn't. The country is run by criminal shyster politicians and banksters, the monied elites, and the corporate oligarchs. We the people are just prey.
The American people have been ripped off by every pension scheme put out there and we are supposed to believe that with ROTH "this time is different"?
First, we have these corporate oligarchs walking away from providing pensions, but promising "very good private alternatives." Then there is Social Security, raided by the government for the past 30-years and now bankrupt. Then there are the Public Employee Pensions, "under-funded" (read stolen from) and soon to be welched upon by governments everywhere. The biggest offender of them all, the phony 401Ks, that were over invested in the stock market (read stolen by Wall Street) with most people losing almost 40 to 50-percent of their funds in the 2008-09 crash; not to mention being raped by these "management fees". All this, and having the value of the dollar falling faster then people are getting older is costing people to have to defer their retirements for like forever.
And in the same spirit of "let's rape the people," we have a new induced, incentivized, mandated and mandatory, compulsory required revenue stream -- Obamacare -- to subject the American people to another fully abusive, corrupt system, the very flower of Capitalism.
Aside from the no minimum distribution requirements, if one does the math, the only reason to do a roth (or convert a regular IRA to a Roth) is if you expect to be in a lower tax bracket when you take the money out.
Since most people have higher taxable income when they are working, most should do the regular IRA or 401k.
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