ROTH ROLLOVERS & CONVERSIONS
Distributions from one Roth IRA can be rolled over tax-free to another Roth IRA. This is done by simply following the general rules for IRA rollovers: re-deposit of funds within 60 days and no more than one rollover each year. Similarly, assets held in a Roth IRA can be transferred directly from trustee to trustee, just as in traditional IRAs. There is no limit on how frequently direct transfers may occur.
Special rules apply, however, where assets are moved from a traditional IRA into a Roth IRA — a so-called “conversion”. These types of “conversions” must be accomplished within the 60-day limit, but the law waives the “once a year” rule for conversions from traditional to Roth IRAs.
Conversions are allowed only if the taxpayer files individually or jointly (but not “married filing separately”) and has adjusted gross income for the tax year of less than $100,000 — not including any amounts resulting from the rollover. The $100,000 income limit will exist through tax year 2009. Beginning in 2010, all taxpayers regardless of income levels will be permitted to convert their traditional IRA into a Roth IRA.
Individuals may make a conversion without physically taking a distribution. An individual may make a conversion by simply notifying the IRA trustee. Or, a conversion may be made via a trustee-to-trustee transfer. Note, however, that if only a part of an IRA balance is converted into a Roth IRA, the Roth IRA amounts must be held separately from traditional IRA balances.
The taxpayer who converts from a traditional account to a Roth IRA must pay ordinary income taxes on the amount converted. Technically, the conversion is a distribution from the traditional IRA (and a subsequent redeposit into the Roth) — and it is taxed as a distribution from a traditional IRA. In the case of “conversion”, however, the 10% early withdrawal tax does not apply. (The 10% penalty on premature withdrawals does apply if funds are subsequently withdrawn from the converted Roth account within five tax-years of the conversion or prior to age 59½, death or disability. This is the only time the 10% penalty tax applies to a Roth account. Without this provision, funds could be converted from a traditional IRA into a Roth IRA simply to avoid the penalty tax.) The 5-year holding period for the “new Roth IRA” begins with the tax year in which the rollover conversion was made — and each converted Roth account maintains a separate holding period.
Please note: Roth 403b (tax sheltered annuities) and Roth 401k plans have been available since 2006. Assets in these plans, funded with after-tax dollars, can be rolled over or transferred to a Roth IRA. These are not subject to income taxation when converted (as the contributions to those accounts were already taxed). The five-year holding period begins when the Roth IRA was first established. Assets in a Roth IRA many not be rolled over or transferred into a Roth 401k or Roth 403b plan.
The tax code permits those wishing to transfer “non-Roth” assets held in employer retirement accounts into a Roth IRA to do so, but the process is two-step: direct transfer or 60-day rollover of the qualified plan assets into a traditional IRA and then a taxable conversion of that traditional IRA into a Roth IRA. This process will be streamlined beginning in tax year 2008 and thereafter — qualified plan assets can be rolled over and converted into a Roth IRA in a single step. Obviously, taxes are owed upon such a conversion, either under the current two-step process or the new single-step rollover / conversion.
The Decision to Convert
The decision whether to convert assets into a Roth IRA is complex. Each individual must determine how the conversion will affect his or her unique situation. The most obvious factors to consider are current and anticipated future tax rates — does the taxpayer foresee being in a higher tax bracket when he or she retires? … and does that possibility offset the certainty of current taxes owed upon conversion? Given anticipated deficits in the federal budget, Social Security and Medicare trust funds, one could conclude that future tax rates will probably increase.
In addition to incurring an immediate tax liability in the year of conversion, other factors may also be affected. For example, will a higher reported income in the year of conversion push the taxpayer into a higher tax bracket? Or cause Social Security benefits to be taxable? Will a higher income make the taxpayer ineligible for other tax breaks or benefits? Many tax deductions and credits are based on adjusted gross income, as is financial aid for higher education. At higher levels of income those deductions, credits and other benefits may not be available.