Roth Conversion FAQ

Roth IRAs

What are the benefits of a Roth IRA?

Withdrawals
Withdrawals of earnings from your Roth account are income tax-free as long as you're at least 59½ years old and have had the account for the minimum holding period (currently five years).

Also, unlike traditional 401(k)s and IRAs, Roth accounts don't require you to take minimum distributions starting at age 70½. However, if you convert to a Roth IRA after age 70½, you still have to take one final required minimum distribution (RMD) from your traditional retirement account for the conversion year.

With a Roth IRA, you also have the ability to take qualified early distributions without paying the early distribution penalty. Early distribution exceptions include, but are not limited to:

• Qualified higher education expenses.
• First-time home purchases.
• Qualified medical expenses.
• Qualified disability claims.

Roth IRA conversion basics

• The IRS is lifting the MAGI limits in 2010 (currently $100,000 or less), thereby making anyone who holds a traditional IRA account eligible to convert it to a Roth IRA.
• A conversion is usually reported as income for the tax year the conversion takes place. However, in 2010 only, your conversion amount will be split and reported as income for tax years 2011 and 2012 unless you elect to report the entire conversion amount on your 2010 taxes.

Which accounts can be converted to a Roth IRA?
You can currently convert traditional IRAs and certain employer-sponsored retirement accounts (such as 401(k)s) to a Roth IRA account. However, in the case of inherited accounts, you can only convert to a Roth IRA if you inherited the traditional IRA from your spouse. Check with your plan administrator and Roth IRA provider.

Who can convert to a Roth IRA?
There is no age limit for converting traditional retirement assets to a Roth IRA.

In 2009, you're eligible to convert to a Roth IRA if your MAGI is $100,000 or less.

In 2010, the IRS is lifting the MAGI limit, meaning everyone will be eligible to convert to a Roth IRA.

Although the IRS is lifting the MAGI limit for conversions, it's important to note that the MAGI limits will still apply for Roth IRA contributions (read more).
 
Can I convert to a Roth IRA even if my MAGI is more than $100,000?
In 2009, you're only eligible to convert to a Roth IRA if your MAGI is $100,000 or less.

In 2010, the IRS is lifting the MAGI limit, meaning everyone will be eligible to convert a Traditional IRA to a Roth IRA.

What is a partial conversion?
A partial conversion gives you flexibility to choose how much of your traditional retirement assets you'd like to move into a Roth IRA account. Investors who choose partial conversions instead of full conversions likely do so for one or both of the following reasons:

• Income taxes: A full conversion, which requires you to report all of the conversion amount as income on your taxes, may end up bumping you deep into a higher federal tax bracket. If you get bumped to a slightly higher tax rate, such as from the 25% bracket into the 28% bracket, the conversion benefits might outweigh the difference in taxes. However, if the conversion causes you to move to a substantially higher tax rate, say from the 15% bracket to the 25% bracket, the increase in taxes owed could be substantial (depending on how deep into the next bracket you end up). (Note: Only the portion of your taxable income that falls into the higher bracket will be subject to the higher rate.)
• Conversion taxes: If you don't have enough cash available outside of your retirement account to pay the tax on a full conversion, a partial conversion might be a better alternative. It may make sense to figure out how much conversion tax you can pay without dipping into IRA assets, and then figure out how much you can convert for that amount of tax. Of course, if you have to sell appreciated assets in taxable accounts to pay the conversion tax (and thereby incur capital gains tax in the process), then the analysis may be more complex. You'll probably want to get some help crunching the numbers from your tax advisor or account.

Can I put my converted assets into an existing Roth IRA?
You should be able to convert all or part of your traditional IRA to an existing Roth IRA. Check with your account provider.

Will I need to sell and go to cash to convert to a Roth IRA?
No. You can convert your traditional retirement assets directly into a Roth IRA without going to cash first.

Do I still have to take a required minimum distribution from my traditional IRA if I convert it to a Roth IRA before the end of the year?
If you convert your traditional retirement assets to a Roth IRA after age 70½, you are still required to take one final minimum distribution for the year you convert (if you haven't already done so). Keep in mind that the IRS has suspended required minimum distribution rules for the 2009 tax year only.

I've heard from one source that converting to a Roth is always a bad idea, while another says it's always a slam dunk. So, which is it?
We suggest that you be wary of extreme points of view. It’s impossible for any advisor to know a person’s unique situation—and whether a Roth would be advantageous—without going over the person’s facts one on one. A Roth conversion may or may not make sense for you, depending on your individual circumstances. So, it’s best to keep an open mind.

One important point, however, is that converting today means incurring a real and permanent tax liability now in hopes that it will pay off at some distant point in the future. Unfortunately, you won't know for sure if the conversion was the right move until you're ready to withdraw the money in retirement.

With the stock market still well below its previous highs, is this a good time to convert to a Roth?
The decision to convert has little to do with the size of your portfolio, so no matter what effect the recent stock market fluctuations had on your portfolio, the market shouldn't inform your decision. Instead, base your decision to convert on an objective assessment of your current tax and financial situation and your reasonable expectations for your future tax bracket.

For example, let's say you have a $100,000 traditional IRA. After running the numbers, you find that it doesn't make sense to convert to a Roth IRA because you believe you will end up with more money 20 years from now by leaving your traditional IRA alone. If that same IRA was to drop 20% because of stock market volatility but your circumstances remain the same, you should still leave it alone. If your analysis turns out to be correct, you’ll still end up with more money at the end of the day by leaving the traditional IRA where it is.

Of course, if you were previously planning to convert because a Roth conversion made sense for you before the decline in the value of your account, then go ahead and convert, provided it remains advantageous given your personal circumstances.

Likewise, if you previously converted to a Roth and the value of your conversion balance subsequently declined, you can undo the transaction via the recharacterization process described below, and then reconvert after the required 31-day waiting period.

Finally, it's important to remember that you don’t have to convert your entire account. If you were planning on making a partial conversion of a fixed amount anyway, it shouldn’t matter what the stock market is doing.

How do I switch or convert to a Roth IRA?
If you hold a traditional IRA at Schwab, call a Schwab Roth Conversion Consultant at 800-424-5750 to get started today.

If you hold a traditional IRA at somewhere other than Schwab, you have two options:

1. Transfer your IRA to an identical IRA at Schwab. When the transfer is complete, you can initiate the conversion to a Roth IRA.
2. Convert your traditional IRA to a Roth IRA while still custodied at your other institution. When the conversion is complete, you can then initiate the transfer of your Roth IRA to a Schwab Roth IRA.

IRA Contributions

Where can I find my pre-tax contributions?
For a traditional IRA, you've likely been keeping track of your cumulative non-deductible traditional IRA contributions all along on IRS Form 8606.

How do I find out how much non-taxable contributions I have in my current account?
If you've been keeping track, your most recent IRS Form 8606 will contain the amount of non-tax deductible contributions.

Can I contribute to my Roth IRA once I’ve converted?
Although the IRS is lifting the modified adjusted gross income (MAGI) limit for Roth IRA conversion in 2010, the MAGI limits for Roth contributions still apply.

There is a potential loophole, however. As the law currently stands, starting in 2010, high income earners otherwise not eligible to make Roth contributions could make nondeductible contributions to a traditional IRA and then convert to a Roth the next day with no federal tax consequence whatsoever. It's likely that this isn't what Congress intended, however, so we wouldn't be surprised if Congress writes some sort of anti-abuse provision into the law to prevent high earners from taking advantage of this loophole.

• Single individual: If you're a single tax filer, you can make the maximum-allowed contribution to a Roth IRA if your MAGI is below $105,000. If your MAGI is between $105,000 and $120,000, then you can contribute some amount less than the full limit. If your MAGI is $120,000 or above, you are not eligible to contribute to a Roth IRA for 2009.
• Married individuals filing jointly: In this case you can contribute to a Roth IRA, up to a limit, if your MAGI is below $166,000. If your MAGI is between $166,000 and $176,000, then you can contribute some amount less than the full limit. If your MAGI is $176,000 or above, you are not eligible to contribute to a Roth IRA for 2009.

IRA Recharaterization

Taxes

1. Traditional IRA balance = $1,000
2. Current federal income tax rate = 25%
3. Future federal income tax rate = 25%

If you pay the 25% conversion tax using IRA funds, you are left investing $750 in your Roth. Assuming an average annual return of 6%, after 20 years you will have $2,405 in your Roth. If, instead, you left your traditional IRA alone and earned the same return, you would have $3,207 after 20 years. Assuming the same tax rate of 25%, you would end up with exactly the same amount after withdrawing the money and paying $802 in federal income taxes: $2,405.

Of course, converting to a Roth would be worse if you were under 59½ at the time of conversion and used IRA funds to pay the tax since you would also incur a 10% federal penalty (state penalty and taxes may also apply).

You still need to account for the “opportunity cost” of paying the conversion tax with funds available outside of your retirement account, since that money could have been invested all along if you just did nothing and left your traditional IRA alone.

However, as you factor in the hypothetical opportunity cost in your analysis, remember that the ongoing return lost to taxes each year and long-term capital gains tax at liquidation of these outside funds are likely less than the ordinary income tax rate you would incur on a future withdrawal from a traditional IRA (which is why there would be a slight advantage with the Roth conversion if you paid the conversion tax with outside funds, even if the future tax bracket remained the same).

What are the chances that the tax-free nature of a Roth IRA will be reversed?
At this time there is no indication that the Roth IRA's tax-free nature will be eliminated. Of course, tax law is subject to change, so a key part of any decision to contribute or convert to a Roth IRA is what you expect your current and future income tax rates to be. Keep in mind that your future income tax rate does not simply depend on your expected level of future taxable income, which is difficult enough to project. It also depends on the tax brackets that may or may not be in place far into the future, not to mention whether our current overall tax system will continue to remain in place (for example graduated tax rates vs. flat tax).

Given government deficits and the likelihood that income tax rates are heading higher, is now a good time to convert to a Roth IRA?
Unless government spending is reduced dramatically, the general consensus is that taxes can only go higher at the federal, state and local levels. Of course, there is a limit at which higher taxes would have a negative effect on the economy, defeating the goal of higher revenue collection. If combined income tax rates (federal, state and local) rise too much, economic activity could fall significantly, paradoxically reducing overall tax revenue.

Policy aside, whatever happens with respect to future tax rates and spending at the federal, state, and local levels, the best you can do is to create a plan based on what you know now about current tax law and where you expect to be personally with respect to future income. While the future may be impossible to predict with absolute certainty, you likely have a better idea of your future situation than of what the federal or state governments might do.

Assuming our current system of graduated tax brackets based on personal income levels remains in place, you will still have a lot of control over how you structure your income. For example, if you have a large retirement portfolio, you can place tax-free municipal bonds and assets that generate long-term capital gains in your taxable accounts so that your marginal tax bracket in retirement ends up being much lower than during your working years—which would make a Roth conversion now less attractive.

On the other hand, your traditional IRA balance may be so large that required minimum distributions (RMDs) starting at age 70½ would push you into a much higher income tax bracket—which would favor a Roth conversion now.

Because the future of taxes is so uncertain, it might make sense to extend your diversification policy beyond stocks, bonds and cash to include diversification based on tax treatment, as well. By holding some money in a taxable account, some money in a traditional IRA, and some money in a Roth, you can better manage your future retirement cash flows to take advantage of whatever happens to the tax structure or your personal situation.

Just as you should not put all your investment eggs in one asset basket, you need to be careful about taking an all-or-nothing approach with respect to the type of retirement accounts you chose.

Is the 2-year payment of Roth IRA conversion taxes a one-time deal?
Yes. In 2010 only, your conversion income will be split evenly and reported on your 2011 and 2012 federal income taxes unless you elect to include the entire amount on your 2010 taxes instead (which might not be a bad idea if you expect your marginal tax rate to increase in 2011). However, you must convert by December 31, 2010, to take advantage of the 2011/2012 split.

Do I need to pay taxes on traditional IRA gains when I convert to a Roth?
Yes. When you convert your traditional IRA to a Roth IRA, you must pay taxes on the amount converted from pre-tax contributions plus any investment gains. If you've made nondeductible contributions to your traditional IRA in the past (hopefully, tracked all along on IRS Form 8606), you can't pick and choose which portion of the traditional IRA money you want to convert to a Roth.

The IRS looks at all assets within a traditional IRA as a whole when it comes to distributions, including Roth conversions. Traditional IRA balances are combined so that the amount converted consists of a prorated portion of taxable and nontaxable money. For more on the aggregation rule, see IRS Publication 590.
 

Estate planning

• Unlike traditional IRAs, Roth IRAs don't require people age 70½ or older to take minimum distributions, which means your account can continue to grow tax-free until your heirs are ready to withdraw the money. If your spouse inherits the Roth account, he or she will not be required to take any minimum distributions, either.
• By paying the conversion tax up front, you eliminate the income tax your heirs would otherwise have to pay on withdrawals from an inherited traditional IRA.
• Converting to a Roth will reduce your taxable estate by the amount of income tax you pay to convert. The Roth IRA balance will still be included in your taxable estate.