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4 Steps to an Effective Roth IRA Conversion

Last Updated December 17, 2015

by Denise Appleby

Studies show that an increasing number of individuals are funding Roth IRAs. One of the primary reasons is the potential for tax-free growth. Unlike traditional IRAs, where earnings are tax-deferred and taxable when withdrawn, earnings in a Roth IRA can be tax-free if distributions are qualified.

While funding a Roth IRA can be an easy process, mistakes can be made. As such, care must be taken to ensure that it is done properly. The following are some general guidelines that can be followed if you are considering funding a Roth IRA with a conversion.

1.       Perform  a Suitability Analysis

As with many other financial strategies, there is no one-solution-fits-all when it comes to Roth IRA conversions. As such, an analysis should be done to determine whether a Roth IRA conversion is suitable for you. Ideally, your suitability analysis should be done before you perform your Roth IRA conversion. However, just in case you want to have a recharacterization done, it can still be done afterwards, providing it is done in time to allow for the recharacterization (see below under “Change Your Mind? A conversion can be reversed”).

One of the primary objectives of a Roth conversion analysis is to determine if you would pay less income tax by converting the amount, instead of keeping the amount in your traditional IRA. To that end,, a Roth IRA conversion analysis takes factors into consideration such as your retirement horizon, your current vs projected future tax-rate, whether you have assets outside of the retirement account to pay any income tax that might be due on Roth conversion, and the ages of your beneficiaries.

2.       Convert by Year-End

A Roth IRA conversion is done by rolling over amounts from a Traditional, SEP, or SIMPLE IRA, or other eligible retirement account to a Roth IRA.

In order for a Roth conversion to be done for this year, the amount must leave the non-Roth account by December 31 of this year.

If you are considering doing a Roth conversion for this year, ensure that the instructions are provided to the custodian or plan trustee on a timely basis. In some cases, custodians and trustees require such instructions a few weeks before year-end, so as to guarantee that it will get processed by the end of the year.

3.       Make Proper Withholding Election

The delivering side of a Roth conversion is treated as a distribution, and is subject to income tax withholding rules.  For conversions from a Traditional, SEP or SIMPLE IRA, you can chose to have no income tax withheld, or choose to have 10% or more withheld.

Any amount withheld for income tax is not treated as part of the conversion. For example, if you request to have an IRA with a market value of $100,000 converted, and elect to have $10,000 withheld as income tax, only the $90,000 credited to the Roth IRA is considered a conversion. The $10,000, which would be paid to the IRS as withholding tax on your behalf, is not part of the conversion and therefore would not be eligible for recharacterization.

If you do not want to have income tax withheld, you must make that election on the Roth conversion request. If you fail to make a withholding election, the IRA custodian must withhold 10% for federal income tax.

4.       Ensure Amount is “Eligible” for Conversion

Only eligible amounts should be converted to your Roth IRA. Ineligible amounts include required minimum distributions (RMD), excess contributions, and amounts from Inherited IRAs.

If you are required to take an RMD for the year, that amount must be withdrawn before the conversion.

Ineligible amounts that are converted to your Roth IRA may create excess contributions, which could be subject to excise tax if not corrected timely and properly.

Change Your Mind? A conversion can be reversed

One of the attractive features about a Roth IRA conversion is that it can be reversed if you change your mind. This reversal process is referred to as a recharacterization. Recharacterizations must be completed by your tax filing due date, plus extensions. For instance, if you file your 2015 tax return by your due date, you receive an automatic 6-month extension. This means that you would have until October 15, 2016 to recharacterize all or a portion of any 2015 Roth IRA conversions.

A recharacterization must meet certain requirements, in order for it to be effective. See Five Steps for Recharacterizing Your Conversion or IRA Contribution

If you are considering doing a Roth IRA conversion, or you want to recharacterize a Roth IRA conversion, please contact your financial advisor for assistance.