The laws of the land and of IRAs changed for the tax year 2010. Previously, anyone who wanted to convert their traditional IRA to a Roth had income restrictions. That's not true anymore. Regardless of your income, you can now convert any type of IRA to a Roth. In the early years of the IRA, people often put funds into non-deductible traditional plans to get the benefit of tax-deferred growth. Today, many now have the ability to convert those same plans into a Roth. There are tax ramifications when you do this and a few rules you must follow.
Estimate your tax bill before you convert. You have to pay taxes on the entire amount of growth, but not on the money you put into the plan. If you had $10,000 of growth and a high income, you could pay close to $4,500 in taxes when you consider state tax. For those converting in 2010, you can spread the tax payment over a two-year period, paying half in 2011 and half in 2012. After 2010, the benefit disappears.
Avoid squeezing your budget and don't expect to use some of the funds to pay the tax. Any money your remove, even if it's for tax payment, has a 10 percent penalty if you're under 59 1/2. If you want to convert but can't afford it all at once, do it a little at a time.
Convert all deductible or non-deductible traditional, SEP or SIMPLE IRAs in a proportional manner using the value at the end of the year. If you have one totally tax-deductible IRA account with a $16,000 balance, another non-deductible IRA with $8,000 balance of which $2,000 was growth, and a SIMPLE or SEP IRA worth $8,000 you can't simply convert the non-deductible IRA. Instead, you must take from all three in proportional amounts. Since the three accounts equal $32,000, the two $8,000 accounts comprise 25 percent each and the $16,000 account comprises 50 percent of your total IRA money. Therefore, any conversion amount must contain 25 percent of your money from each of the $8,000 IRAs and 50 percent from the $16,000 one. You can use Form 8606 to calculate the percentages. Since your total basis, the amount you contributed after tax, to the non-deductible IRA was 25 percent of the total value of that particular account; you multiply the $2,000 that came from it by 25 percent. This gives you $500 of non-taxable funds converted to the Roth. You'd pay tax on the other $7,500.
Select your investment company. The easiest way to transfer the funds is directly from trustee to trustee. The company you select can be the one that presently holds one or all your other IRAs. You need to fill out the paperwork to open an account and paperwork for the direct transfer of funds. If you have more than one IRA, you need a transfer form for each IRA. If you already have a Roth account, simply complete the transfer forms.
Check for loopholes. If you have a rollover IRA from an old 401k or pension which you kept in a separate account, you can roll it into a 401k at work before the end of the year if you work for a company with a plan that allows it. This reduces the total in taxable IRAs and lets you convert more non-deductible money, lowering your taxable amount.
- Time the conversion for you biggest benefit. Convert your funds when your investment slumps to take advantage of the lowered taxable amount.