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How Do I Convert my traditional IRA to a Roth IRA?

Beginning in 2010, the income limitations that have prevented taxpayers with modified adjusted gross incomes of $100,000 or more and married taxpayers that filed their returns separately from converting a traditional individual retirement account (IRA) to a Roth IRA are eliminated entirely. As a bonus to kick off “unlimited Roth conversions,” any income tax payments due on 2010 conversions may be deferred into 2011 and 2012. For higher-income individuals, 2010 presents a long-awaited and much anticipated opportunity to convert their savings into a Roth IRA providing tax-free distributions during their retirement years.

Eligibility for a Roth conversion in 2010 does not automatically make it a good decision for every taxpayer. Indeed, under the right circumstances, converting to a Roth IRA can provide potential significant tax and financial benefits. But every individual’s needs and circumstances are unique, and a Roth IRA conversion must be assessed in light of your particular tax and financial situation. In addition, converting to a Roth IRA is not a “do-it-yourself” transaction, and you should consult with a tax professional about the benefits and drawbacks relating to your personal situation.

The new conversion opportunity does not apply to funds held in a 401(k). The conversion opportunity applies to traditional IRAs, in addition to SIMPLE IRAs and SEP plans.

Conversion methods

A conversion to a Roth IRA may generally be accomplished by one of three means:

– Rollover. An IRA rollover involves making an eligible distribution from your traditional IRA that is rolled over into a Roth IRA within 60 days after the distribution. If the rollover does not occur within 60 days, it will be treated as an early withdrawal subject to a 10 percent early withdrawal tax as well as federal (and possible state) income taxation.

– Trustee-to-trustee transfer. If your IRA trustee is the same trustee for your traditional IRA and Roth IRA, you may have that trustee make the account transfer on your behalf. Additionally, if the trustee is not the same, your traditional IRA trustee can also transfer the funds to your new, Roth IRA trustee on your behalf, even if they are not the same trustee for the accounts.

– Account redesignation.

Regardless of type of means you use to convert to a Roth IRA, amounts converted from a non-Roth IRA to a Roth IRA are treated as distributed from the non-Roth IRA and rolled over to the Roth IRA. As mentioned above, a rollover must generally be effectuated within 60 days.

Income tax consequences

The government is encouraging Roth conversions not only to shore up retirement savings but also to gain short time revenues. It accomplishes the latter because a conversion from a traditional IRA is counted as a taxable distribution in which income taxes must be paid. Unlike such distributions outside of a Roth conversion, however, no early withdrawal penalty is imposed. Since you would be taxed on your traditional IRA distributions eventually anyway upon retirement, having the distribution taxed at the time of a Roth conversion can be viewed as an acceleration of that tax. In return, however, the funds that become part of your Roth account, including future earnings of them, become tax free forever into the future.

For conversions taking place in 2010, you have the option to elect to recognize the taxable income generated on the conversion amount ratably in adjusted gross income (AGI) in 2011 and 2012, instead of recognizing it all in 2010. This election does not spread the tax that would otherwise be paid in 2010 to 2011 and 2012; rather, it spreads the income realized in 2010, half into 2011 and half into 2012. That income, half in 2011 and half in 2012, is taxed at 2011 and 2012 rates, respectively, along with any other income normally realized for those years. It is important to “do the math” on this election before making any decision.

Conversion transaction

The institution or brokerage at which you maintain your traditional IRA will generally have a Roth Conversion Form, or similar document, that you must fill out to complete the transaction. The form may ask you for the name and account number of the IRA that you want to convert, whether you want to convert the entire amount of the traditional IRA, or only a part of the account, and the amount of the IRA you want to convert to the Roth IRA (or number of shares). Typically, the form will also inform your federal and state income tax withholding obligations regarding the transaction. You will have the opportunity to elect withholding, or elect not to have anything withheld from the funds in order to meet your anticipated income tax obligations from the transaction.

Note. Whether you pay the taxes on the transaction from the funds transferred to the Roth IRA itself, or with outside funds, is an important decision you make. In general, taxpayers are better off paying the tax, if they can, with funds outside the account. You should discuss the taxation aspect of the conversion with your tax advisor.

If you have any questions about converting your traditional IRA to a Roth IRA, please contact our office. We can help determine if converting your account is the best decision considering your financial and tax situation and needs, and help you with the transaction.

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If and only to the extent that this publication contains contributions from tax professionals who are subject to the rules of professional conduct set forth in Circular 230, as promulgated by the United States Department of the Treasury, the publisher, on behalf of those contributors, hereby states that any U.S. federal tax advice that is contained in such contributions was not intended or written to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer by the Internal Revenue Service, and it cannot be used by any taxpayer for such purpose.