Q. I know youve written about this subject before, but please explain the rules and benefits of converting an IRA to a Roth IRA. What is the income limit for those wishing to convert? Is there a better time of year to convert than another? Is it too late to convert an IRA to a Roth IRA for 2013? I understand that if I change my mind and want to undo the conversion I can, what are those rules?
A. There used to be an income limit, but since 2010, anyone can convert an IRA to a Roth IRA. You will owe income tax on the amount converted and it is best if you have money to pay this tax available in a nonretirement account. In general, a conversion usually makes sense if you think you will be in the same or a higher tax bracket in the future. The more years you have before you will need to use the money you are converting, the more a conversion makes sense. The benefit of the long-term tax-free compounding is lost if you tap into the converted IRA relatively soon after the conversion. Roth IRA conversions are subject to a five-year rule. Each conversion must meet the five-year rule for distributions to be penalty-free. Distributions of the converted amounts five years after the conversion or when the account holder attains age 591/2, whichever occurs sooner, are penalty free. Roth conversions have a Jan. 1 starting date for the five-year rule regardless of when in the year the conversion occurs. If you convert an IRA in December of this year, your five-year period will be met Jan. 1, 2018. Converted amounts are always tax-free and penalty-free if you are 591/2 or older, or meet the five-year test. Distributions of earnings must meet the five- year test to avoid taxes even if you are 591/2 and will be subject to tax if youre younger than 591/2.
The IRS considers withdrawals from a Roth IRA first as a return of contributions (tax- and penalty-free), which you dont have with a conversion IRA, then as a return of converted amounts (tax- and penalty-free if you meet the five-year rule or you are at least 591/2), then any money taken out is considered earnings.
For a conversion to count as a 2013 Roth conversion, the funds must be withdrawn from the traditional IRA by Dec. 31, 2013, and must be deposited in the Roth IRA within 60 days. The simplest way to make your Roth IRA conversion is via a direct roll-over or trustee-to-trustee transfer with the current IRA custodian.
You can re-characterize a Roth IRA. The term re-characterization applies when a taxpayer converts a traditional IRA to a Roth IRA and then decides to change it back or re-characterize it to a traditional IRA. You have until the due date of your 2013 tax return to re-characterize your 2013 conversion (Oct. 15, 2014, with extensions).
A meeting with a financial or tax adviser concerning your personal situation may be beneficial.
Holly Nicholson is a certified financial planner in Raleigh. She cannot answer every question. Reach her at askholly.com or P.O. Box 97128, Raleigh, NC 27624