Roth IRA Rollovers and Conversions

Some things are just not meant to be together: cats and dogs; oil and water; Roth IRAs and traditional IRAs.

Although they can coexist, Roth IRAs and traditional IRAs are just not meant to share the same space. You can have one or the other or both, but you can't treat contributions to them as if they are interchangeable. You can, however, roll over amounts from one Roth IRA to another and, in certain cases, convert a traditional IRA to a Roth IRA.

Tip Any amount distributed from a Roth IRA and contributed to another type of retirement plan (other than a Roth IRA) is treated as a distribution from the Roth IRA. It is not treated as a qualified rollover contribution to the other type of retirement plan.

A rollover between Roth IRAs is virtually identical to rollovers between traditional IRAs. The only difference is that the one-year waiting period for successive rollovers does not apply to Roth IRAs.

Financial Calculators To determine whether a Roth IRA or a traditional IRA will best meet your needs, use this Roth vs. Traditional IRA Calculator

A conversion of all or partial amounts from a traditional IRA into a Roth IRA is treated as a rollover. The amount rolled over from the traditional IRA to the Roth IRA is included in a person's income just like a regular taxable distribution from a traditional IRA. Future earnings, however, can be withdrawn tax-free if they are held in the Roth IRA for five years. Also, the 10 percent penalty on early distributions from a traditional IRA will not apply unless you keep part of the original amount from the traditional IRA or later withdraw part of the amount within five years of the conversion contribution.

Failed conversions. A conversion may inadvertently fail because circumstances may change. In such a case, the contribution will be treated as a regular contribution to the Roth IRA, resulting in the following tax consequences:

• A 6 percent excise tax per year will apply to any excess contribution that is not withdrawn from the Roth IRA.
• The distributions from the traditional IRA must be included in your gross income.
• The 10 percent penalty for early withdrawals from a traditional IRA will apply.

To convert or not to convert? Although that may be the question, there is no clear-cut answer as to whether it is nobler to convert or not to convert your traditional IRA to a Roth IRA. As previously discussed, the benefit to you is to allow all future earnings to be withdrawn tax-free after the five-year holding period. The price you pay for this benefit is having to pay an immediate tax on the converted amount as if you had taken a distribution.

Financial Calculators To help you decide whether to convert to a Roth IRA, use the Roth IRA Conversion Calculator.

A general rule of thumb is that you shouldn't convert funds unless the funds will be untouched for at least 10 years. Obviously, the longer your money can grow interest that will be distributed to you tax-free, the greater the benefit of the conversion will be.

Tip A conversion is treated as a taxable distribution, but is not subject to the 10-percent early withdrawal penalty. Also, taxpayers who converted in 2010 can elect to recognize the conversion income in 2010 or average it over the next two years.

At the same time, other factors need to be considered. Paying tax as a result of a conversion requires that you have the outside income or means to pay the tax. If you can't afford the additional tax liability, making a conversion would not be such a great idea. Also, the marginal tax rates impact the cost-effectiveness of your decision. For example, if the tax rates are very low at present and you expect them to be higher in the future, then it would make more sense to pay a lower tax today than a higher tax later.

Tip If you are a low- or middle-income taxpayer, there is a way for you to enjoy the best of both worlds (i.e. current tax savings and the tax-free growth and distribution of Roth IRA savings). The retirement savings tax credit available to low- and middle-income taxpayers for making retirement savings contributions also applies to Roth IRAs and can provide a tax credit of up to $1,000 ($2,000 if filing jointly). This can provide a significant tax-break in the present, along with the future tax benefits regularly offered by Roth IRAs. See IRS Form 8880 and its instructions for more information.