Converting Funds from a Traditional IRA to a Roth IRA: Factors to Consider

• Guessing incorrectly may have serious consequences; the conversion of funds from a traditional IRA to a Roth IRA is considered a taxable distribution, subject to federal income tax and a possible penalty.

• The fact that you qualify to convert funds from a traditional IRA to a Roth IRA doesn't necessarily mean you should; consider the following factors before making a decision.

• Converting traditional IRA funds to a Roth IRA will result in federal income tax due on those funds (to the extent that those funds consist of investment earnings and tax-deductible contributions).
• Paying the tax due with IRA funds reduces the amount that grows tax free in the Roth IRA.
• IRA funds used to pay the tax may be subject to additional income tax and possibly a penalty.
• Paying the tax due with non-IRA funds allows more dollars to be funneled into the tax-free Roth IRA.

• If your tax bracket remains the same and you pay the tax that results from converting funds with IRA dollars, the conversion may have no tax consequence.
• If you'll be in a lower tax bracket when you take IRA distributions, paying tax now on converted funds at your present (higher) rate may not be very appealing.
• If you'll be in a higher tax bracket when you take distributions, you can convert funds to a Roth IRA now and pay tax at your present (lower) tax rate, and distributions will be tax free later (assuming you qualify for tax-free withdrawals--see below).

• If you withdraw funds after 5 years from the time you establish any Roth IRA you may qualify for tax-free and penalty-free withdrawals if you meet one of serveral other conditions (a qualified withdrawal).

• f you convert a traditional IRA to a Roth IRA, and then make a nonqualified withdrawal within 5 years of the conversion, the earnings you withdraw will be subject to income tax, and your entire withdrawal may be subject to a 10% penalty unless an exception applies (age 59½, etc.).

• This time frame becomes more important when you're paying the tax that results from converting funds with IRA funds.

• Generally, converting funds to a Roth IRA makes sense if you plan to leave the funds in the Roth IRA for 10 years or more.

• If you plan to take distributions from the Roth IRA within the next 10 years, make sure converting funds is in your best interest.

• You can keep contributing to the Roth IRA after age 70½, as long as you have sufficient earned income.

• Unlike a traditional IRA, you aren't required to take annual minimum distributions from a Roth IRA after age 70½ or at any time during your life.

• Assuming 5 years have elapsed from the time you established any Roth IRA, your beneficiary receives Roth IRA funds free from federal income tax (but not necessarily from federal estate tax) when you die.

Does your traditional IRA consist of any nondeductible (after-tax) contributions?

• You've already paid federal income tax on any nondeductible contributions to your traditional IRA, so these dollars are not subject to federal income tax when you convert funds to a Roth IRA.

• After you convert funds, future investment earnings on your Roth IRA will accrue tax free.

• When you die, the value of your IRA (traditional or Roth) will be included in your taxable estate to determine if federal estate tax is due.

• When you convert funds from a traditional IRA to a Roth IRA, you pay federal income tax on your IRA funds now rather than later.

• The money you use to pay the tax now effectively removes those dollars from your taxable estate, potentially reducing your federal estate tax liability after your death.

• When you convert funds from a traditional IRA to a Roth IRA, you pay federal income tax on your IRA funds now rather than later.

• The money you use to pay the tax now effectively removes those dollars from the assets to be considered in determining your child's eligibility for financial aid.

• The portion of your Social Security benefits that is taxable in any year depends on your income and tax filing status for that year.

• Excluding any nondeductible contributions, funds that you convert to a Roth IRA are treated as taxable income to you for that year.

• If more of your Social Security benefits will be taxed as a result of converting funds to a Roth IRA, factor in the additional tax cost to you.

• Balance this cost against the fact that distributions from Roth IRAs, in addition to being tax free, are not currently counted in determining the taxable portion of your Social Security benefits.

• If your state does not follow the federal income tax treatment of Roth IRAs, you must factor in the way that your state tax treatment will affect your situation.

• Up to $1,283,025 (and in some cases more) of your total IRA assets, Roth and traditional, are protected under federal law in the event you declare bankruptcy. State law may provide additional creditor protection, but the protection given to funds in Roth IRAs may be less than that given to funds in traditional IRAs.

• If you have a significant percentage of your assets in IRAs and you are at risk of being sued by creditors, you should consider your state's degree of creditor protection for each type of IRA.