Monday, February 22, 2010

Should You Convert to a Roth IRA? (Part 4)

Should You Convert to a Roth IRA? (Part 4)

I can now firmly tell you that this will be a 5-part series on converting to a Roth IRA. Our goal is to explain the essential points that you, as an investor, must understand and consider as you decide whether or not converting to a Roth IRA will benefit you and your family. Today, we will further discuss the tax implications surrounding these conversions.

 Can I undo a Roth conversion?

Yes, it is possible to undo a Roth conversion through something called a “recharacterization,” which is essentially a “reconversion” to qualified status. Typically, you have until October 15 of the year after a conversion to do a recharacterization.

So if Vickie converted her traditional IRA to a Roth IRA on January 5, 2010, she has until October 15, 2011 to change her mind and undo it.

Will I incur a 10% “early withdrawal” penalty by converting my qualified funds if I am younger than 59½?

Converting to a Roth IRA grants you an exception to the 10 percent early withdrawal penalty rule. That is, unless you withdraw funds from your existing qualified plan to pay the taxes on a conversion, which is considered a distribution and will, therefore, incur income tax plus a 10 percent penalty if you are younger than 59½.

Let’s say Ted is 55 years old and has $150,000 in a 403(b) from his previous employer. If he converts the entire amount to a Roth IRA, he’ll owe income tax but have to pay no penalties, even though he’s not yet 59½.

However, if Ted were to convert only $100,000 and withdrew the remaining $50,000 to pay the taxes due, he would owe income tax on the entire $150,000. In addition, he’d have to pay the 10 percent penalty on the $50,000 because that would be considered a distribution, not a conversion.

After converting to a Roth IRA, do all withdrawals automatically become income-tax free?

It is critical that you pay very close attention to the various situations I describe here, as I have personally noticed and encountered a great deal of misinformation in this area.
  • Regardless of your age, you may withdraw your principal – the initial after-tax funds that went into the Roth account – anytime, without an income-tax hit or a penalty.
  • However, regardless of your age, you will be taxed on any gains you withdraw within the first five years of the conversion.
  • If you are younger than age 59½, you will also pay an additional 10 percent penalty tax on any such gains that you withdraw within the first five years of the conversion, except in the case of certain specifically allowable exceptions.
  • Once the converted funds have been held in the Roth IRA for more than five years and you are older than age 59½, all the gains in the account become income-tax and penalty free. Yeah – finally!
  • Note, however, that even if you have held the account for more than five years but are younger than 59½ years, your gains will be taxed in addition to the 10 percent penalty, except in the case of certain specifically allowable exceptions.

What Are the Specifically Allowable Exceptions?

Generally, when funds are accessed in any of the following instances, they are considered exceptions:
  • Death or disability of the owner
  • Medical expenses
  • Health insurance premiums for the unemployed
  • Qualified higher education expenses
  • Qualified first-time home purchase
  • Substantially equal periodic payments
  • IRS levy
In such instances, the 10 percent penalty tax is waived. However, the income-tax on the gains is not waived except in the case of the death/disability of the account owner OR for a qualified first-time home purchase and the account has been held for more than five years.

In the final post in this series, I’ll offer my professional opinion on whether or not you should convert to a Roth IRA, so I’m sure you won’t want to miss that!

For your free, no-obligation, comprehensive analysis to determine whether it even makes sense for you to consider a Roth conversion, call (301) 949-4449 or schedule your appointment here.

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