Maybe you've had a slow year of sales or you've been laid off, but if you find yourself in a lower tax break, it might be a great year to convert your self-directed IRA to a self-directed Roth IRA. You can pay the tax on the conversion at the lower rate and then take all your distributions, including any gains you generate, tax-free at retirement. Even though the IRA is self-directed, you still have to have a financial institution serve as the custodian of the account for it to be treated as an IRA. Though each financial institution has its own forms, the process is generally the same. After completing the conversion, you will need to include it on your taxes.
Items you will need
- Form 1040 or 1040A
- Form 8606
Contact your IRA custodian to get the forms you need to convert your self-directed traditional IRA to a self-directed Roth IRA. Some financial institutions will require you to separately open a Roth IRA first and then request a transfer of the funds. Other financial institutions may allow you to complete the conversion with one request.
Complete the forms and submit them to your financial institution. Some will require you to submit paper copies, but others will allow you to request the conversion online. Generally, you need to provide your identifying information, including your name, address and Social Security number, the amount that you want converted, and the account information for the self-directed IRA and your self-directed Roth IRA.
Report the amount of the conversion as a tax-free IRA distribution and use Form 8606 to figure the taxable portion. You can use either Form 1040 or Form 1040A to file your taxes. If you haven't made any nondeductible contributions to the self-directed traditional IRA, the entire conversion counts as taxable income.
Report the taxable portion of the conversion as a taxable IRA distribution on your taxes. This is the amount that gets included in your taxable income. The remainder of your tax return is the same as if you didn't convert during the year.
- When you convert to a self-directed Roth IRA, you're going to owe extra in taxes. You can estimate the amount you'll owe by multiplying that amount you're converting by your tax bracket. However, if you're converting a large amount, some of the conversion might push you into a higher tax bracket. If possible, don't pay these taxes out of the conversion amount because it will be treated as a taxable distribution and will be hit with the 10 percent additional tax if you aren't at least 59 1/2 years old.
- Keep the five-year rule in mind with your new Roth. Under this rule, any converted money you withdraw from your new Roth within five years of the opening date will face a 10 percent penalty unless you are 59 1/2. Any part of the withdrawal that represents earnings will also face income taxes in the year you withdraw them, although you won't have to pay income taxes again on any of your converted funds.
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