Converting an IRA to a ROTH IRA

Converting an IRA to a ROTH IRA

What to Consider and What to Keep in Mind.

Future tax rates are key when figuring out if converting to a ROTH is a good idea. Do you expect tax rates to go up or down in the future? Do you expect your retirement marginal tax rate to be the same or greater than your current tax rate? Do you have current IRA assets that are depressed in value? Switching to a ROTH may pay off as long as you don’t have to pay the tax from the converted funds.            

Advantages to a ROTH include tax deferred growth, tax free income and no Required Minimum Distributions at age 70 ½ like the IRAs. Also, after your death, non-spousal heirs such as children or grandchildren must start getting income from the ROTH, but the payouts are tax free. A spouse can inherit a ROTH and can keep it without having to take distributions.

Be sure to consider any side effects of converting IRAs to a ROTH. The additional taxable income from converting can trigger the 3.8% Medicare surtax on unearned income. This hits singles with modified AGI over $250,000. The ROTH conversion income isn’t hit by the surtax, but it is counted in Adjusted Growth Income and can then subject more of your unearned income to the tax. (see page 2)

The same goes for Medicare Premiums. The surcharge starts for singles above MAGI (modified adjusted gross income) $85,000. For marrieds, it starts at MAGI $170,000.

The same goes for Social Security benefits as well as possibly income based phase outs which affects write offs for personal exemptions, itemized deductions, passive loses, etc.

Doing partial IRA to ROTH IRA conversions over several years can prevent the above tax effects.

You have until October 15th of the following year to change your mind following an IRA to ROTH conversion. For example, if the converted account balance later falls in value, you can switch it back to the IRA, recoup the tax paid, then convert again after 30 days at the lower balance for a lower conversion tax amount.

Finally, consider contributing to a ROTH IRA if you are eligible. For the 2015 year, full ROTH IRA contribution eligibility is:

For Singles:
• Under age 50 – $5,500
• Age 50 & Over – $6,500 if AGI < $116,000
• Reduced contribution up to AGI< $131,000                

For Marrieds filing:
• Under age 50 – $5,500
• Age 50 & Over – $6,500; full contribution available up to AGI< $183,000
• Reduced contribution up to AGI< $193,000

One Minute Idea: "Back Door" ROTH IRA - Be aware of the rules

Many want to know how to make a ROTH IRA account contribution even if they are over the IRS stated income limit, or if currently participating in an employer retirement plan.   There is a plethora of things going around the internet that seem to indicate you can do so with no tax consequences which is not the case.  I have had two calls in the last week regarding something seen on the internet as an “easy” way to get around the IRS.   As we all know, nothing with the IRS is “easy” so be aware of any one advising you of a way to make a “back door ROTH IRA” contribution with no taxes.   It is doable but you need to know the rules and any possible tax consequences.

First, according to the IRS rules you are not eligible to make a ROTH IRA contribution if your annual Modified Adjusted Gross Income (MAGI) is at these limits:

• Filing SINGLE $131,000 (contribution phase out begins at $116,000), max contribution per year for those under age 50 is $5,500 and for age 50 and above $6,500;

• Married filing Jointly $193,000 (contribution phase out begins at $183,000), max contribution is same as above for each.

If you technically make “too much money” or if you participate in an employer retirement plan such a 401(k), that would not allow you to do a ROTH IRA contribution, then there is still a way to do a ROTH IRA but it is subject to some rules.

If you have current IRAs, SIMPLE IRAs, and / or SEP accounts, then they have to be taken into consideration.

You can make a nondeductible contribution to a Traditional IRA account then convert it to a ROTH IRA.  (See calculation below for possible tax consequences.) 

The example below assumes person is under age 50 and will put in $5,500 maximum contribution to a nondeductible IRA, then converts it to a ROTH IRA, and already has $183,377 in current IRAs, SIMPLE IRAs, and / or SEP accounts.

The calculation is:    
Tax Free Conversion Amount 
= 100 x ($5500  divided by ($5500 plus total IRAs $183,377)                               
= 100 x ($5500 divided by 188,877)                                 
= 100 x .0291194                                                      
= 2.91194 %

So the taxable amount of the $5500 conversion would be:  100 minus 2.91194 % = 97.08806% x $5500 =  $5,339.84 of the conversion amount would be taxable.

One way to avoid the tax is if you have traditional IRAs then you may be able to transfer those to an employer 401(k) plan since that type account is not counted in the calculation.  

I encourage you to take advantage of your employer plan matching contribution then consider a personal ROTH IRA in addition.

Consult your tax advisor and call me to discuss your current financial picture and goals.

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