Roth IRA Conversions - Eligibility, Types of Conversions and Adjusted Gross Income Limits

(March 13th, 2008)

The Roth IRA is a better choice than traditional IRA because contributions are made after-tax adding greater tax leverage to your retirement savings allowing you to grow your savings tax-free and withdraw them tax-free! What happens if you already have a traditional IRA and would like to convert it to a Roth IRA? This is where Roth IRA conversions come into play!

Qualified Roth IRA Conversion

In order to successfully convert a traditional IRA to a Roth IRA, the conversion must be 'qualified.' Roth IRA conversions are treated as rollovers at all times, regardless of the method used. There are 3 of these methods, discussed below:

i) Rollover - You can take a distribution from a traditional IRA and roll it over to a Roth IRA within 60 days. To meet the 60 day rule, count the day you receive the check and include the day when you deposit the money into your Roth IRA. For example if you get the check on April 1st, 2008, you must have it deposited by May 30th, 2008. There is no extension granted for holidays and weekends.

ii) Trustee-to-trustee transfer - You can instruct the trustee of your traditional IRA to make a direct payment to the trustee of your Roth IRA. This is also considered a qualified rollover.

iii) Same-trustee transfer - If you have only 1 trustee for both your traditional IRA and your Roth IRA, you should instruct the trustee to transfer directly from traditional to Roth IRA.

Adjusted Gross Income Limits

The law states that if your adjusted gross income (AGI) is greater than $100,000, you cannot convert from a traditional IRA to a Roth IRA. This law applies to both singles, married filing joint & head of household filers. Note that if you are filing a married-filing-separate tax return, you are not eligible to convert a traditional IRA to a Roth IRA at all, no matter what your adjusted gross income is.

An interesting question asked is, what if you made a Roth conversion last January and find out that your adjusted gross income will exceed $100,000? If this happens, there is nothing to worry about. You can convert your Roth IRA back to a traditional IRA via a few simple procedures known as IRA Recharacterizations.

Example

John has an AGI of $85,000. He also has a traditional IRA of $55,000 that he would like to convert to a Roth IRA. John's official adjusted gross limit (AGI) threshold for the year would be $85,000. Note we do not include the $55,000 conversion in the AGI limit because the law forbids that.

John has an AGI of $85,000. He also has a traditional IRA of $55,000 that he would like to convert to a Roth IRA. John's official adjusted gross limit (AGI) threshold for the year would be $85,000. Note we do not include the $55,000 conversion in the AGI limit because the law forbids that.

Conversion Tax Effects

So you've decided to make a Roth conversion; there are some tax consequences you should consider before doing so. Funds converted from a traditional IRA to a Roth IRA that would have been taxable if the distribution had not occured as a 'qualified rollover' will be subject to income taxes at your current tax bracket. If your traditional IRA consists of prior deductible contributions (contributions that you have already deducted from your employment income to give you a tax break) will be taxed at the time of the conversion. Similarly, if your traditional IRA consists of prior non-deductible contributions (contributions that you have NOT deducted from your employment income to give you a tax break) will NOT be taxed at the time of the conversion.

Also note that if your IRA consists of funds from a prior rollover from another qualified retirement plan such as 401k, 403b plan, SEP plan, etc, all of the funds converted will be taxable at the time of conversion. Because the conversion you are making is 'qualified', there is no need for you to pay the 10% early withdrawal penalty, thus exempting you from that.