Roth IRA info from Vanguard
1. What are the differences between a traditional IRA and a Roth IRA?
With a traditional IRA, your contributions are generally tax-deductible, and your account can grow tax-deferred over time. Later, when you take withdrawals in retirement, withdrawals will be taxed at your ordinary income tax rate. And once you reach age 70½, you'll be required to take minimum distributions annually. So, if you're looking for a tax break today, and you think you might be in a lower tax bracket later on, a traditional IRA could be a good choice.
With a Roth IRA, on the other hand, your contributions are not tax-deductible, but your earnings can grow tax-free and won't be taxed when you take withdrawals in retirement, provided you meet some basic criteria. Also, you aren't subject to required minimum distributions during your lifetime.
So, if you'd rather get that tax obligation out of the way now rather than in retirement—particularly if you think you might be in a higher tax bracket at that point in life—a Roth IRA might be better for you.
2. What's a Roth conversion?
It's the process of transferring assets from a traditional IRA into a Roth IRA. For instance, if you have a traditional IRA here at Vanguard, you could open a new Roth IRA and transfer money into it.
Although you're not physically taking possession of the assets from your traditional IRA, the IRS considers the pre-tax amount you're transferring to be a taxable distribution. Vanguard will send you forms 1099-R and 5498 to report the distribution from the traditional IRA and conversion into the Roth IRA, which you'll need when you file your tax returns.
3. Why are Roth conversions getting so much attention?
Until January 1, 2010, you weren't eligible to do a Roth conversion if your modified adjusted gross income was more than $100,000, or if you were married and filing separate tax returns. But those restrictions have been eliminated, making Roth conversions an option for many more people.
Also, if you perform a conversion in 2010, you don't need to report all of the resulting income on your 2010 tax return. The default method (for 2010 conversions only) will be to spread the income evenly across 2011 and 2012—a 50/50 split. Alternatively, you can elect to include all of the income on your 2010 tax return.
4. What are the benefits of converting?
By converting to a Roth IRA, you're paying income taxes on the pre-tax traditional IRA balance in exchange for the tax-free growth potential offered by a Roth IRA. The appeal for taxpayers who expect to be in a higher tax bracket in retirement is that they'd rather pay those taxes at a presumably lower rate now.
If you think your future tax bracket will be higher, a conversion may make sense for you. But if you expect to be in a lower bracket, it might not be beneficial. And if you're not sure what bracket you'll be in, you could diversify your tax posture through a partial conversion—that is, moving only a portion of your assets into a Roth IRA and leaving some in the traditional IRA. It doesn't have to be an either/or decision.
5. When do I have to pay taxes on a Roth conversion?
If your Roth conversion results in taxable income, you don't need to send a check to the IRS that very day. You'll receive a Form 1099-R by January 31, 2011, reporting conversions in 2010. The pre-tax balance of the distribution is considered ordinary income, which you must report to the IRS when you file your income tax return. (See question 3 for your tax reporting options.)
6. How do I determine the tax impact of my IRA distribution?
The pre-tax balance of the traditional IRA being converted will result in taxable income and will be aggregated with other ordinary income. If converting to a Roth IRA results in taxable income, you may not know exactly how much you'll owe the IRS until you prepare your return. But you can make an estimate—for example, by adding the taxable amount of the conversion to your prior-year income and considering the potential impact to any deductions or credits. There are online online calculators and tools to help you estimate the tax impact, or you may want to think about contacting a qualified tax professional.
7. Could a conversion push me into a higher tax bracket?
Yes. Even though you're not receiving the money directly, the pre-tax assets you take out of a traditional IRA for a Roth conversion are treated as taxable income and could move you into a higher marginal tax bracket. If that's a concern, you might consider a partial conversion—that is, converting just enough of your traditional IRA to keep you in your current marginal tax bracket. You could then do additional conversions in subsequent years.
8. What if I'm facing a large taxable distribution as a result of my Roth conversion, and I don't have the cash on hand to pay the tax bill?
You can use IRA assets to pay taxes you owe on a conversion. But using IRA assets to pay a tax bill obviously represents a lost opportunity for future investment growth. Also, if you're under age 59½, money you withdraw from your IRA (or have withheld) to pay the taxes may be subject to a 10% IRS penalty.
Using nonretirement assets to pay your taxes lets you convert the entire pre-tax balance of the IRA to the Roth. If that's not an option, you could think about doing a partial conversion instead. Or you may simply decide that a Roth conversion isn't right for you at this time.
9. Where are tax rates headed in the near future?
Barring unforeseen legislation, tax rates are set to go up at the end of this year for everyone except those in the 15% tax bracket:
If you're deciding whether to report taxable income from a Roth conversion in 2010 or to split it evenly over 2011–2012, it's important to consider the possibility that you may be paying at a higher tax rate beginning next year. Be sure to consider your personal tax situation as well.
10. Do I owe both federal and state income tax on my Roth conversion, or just federal?
Conversions are subject to federal taxes and may be subject to state taxes. The rules vary from state to state, so it's a good idea to look at your state government website or speak with a professional tax advisor.
11. If I convert more than one IRA in 2010, can I treat each account separately and report income for one in 2010—and then defer the income over 2011–2012 for the others?
Unfortunately, no. For tax reporting, when the IRS looks at your IRA balances, it's looking at them in aggregate. The same tax treatment must be applied to all conversions done in the same year.
12. My spouse and I file taxes jointly, but we have separate traditional IRAs. If we each convert our IRAs in 2010, can one of us report the income for 2010 while the other spreads it across 2011 and 2012?
Given that the IRAs are owned individually, you and your spouse should be able to elect individually how to report any conversion income.
13. Does a Roth IRA conversion make sense for someone who's already retired?
Everyone's situation is different, but if you're retired and depending on your IRA for current income—or if you're spending required minimum distributions—a conversion probably doesn't make sense because of the potential for an immediate tax impact.
On the other hand, if you're not tapping your IRA and you want to pass those assets on to your beneficiaries, a conversion could be a smart move, especially if your beneficiaries are in a higher tax bracket. In effect, by converting to a Roth and paying taxes on that distribution now, you'd be prepaying taxes your heirs might otherwise owe.
14. Is a Roth conversion a good move for younger investors?
If you're in your 20s or 30s, you have a long time frame and can benefit from many years of potential tax-free growth with a Roth. Plus, your peak earning years are probably ahead of you, and there are a lot of uncertainties around future tax rates. That means investing in a Roth—or doing a conversion—could be a good idea, as you'll be taking care of any tax obligation at a presumably lower tax rate than you would likely pay in the future. You may also have a pre-tax employer-sponsored retirement plan, so holding different account types can give you additional flexibility in the future.
Just remember that if you're under age 59½, any money you take (or have withheld) from your IRA to pay taxes on a distribution resulting from a Roth conversion would be subject to a 10% IRS penalty (in addition to the tax itself).
15. What are the tax consequences of converting a nondeductible IRA to a Roth IRA?
If your income exceeds IRS limits, you can't contribute directly to a Roth IRA, but you can invest in a nondeductible traditional IRA. Your account can grow tax-deferred, but you don't get a deduction during the year of the contribution, and you'll owe taxes only on the earnings when making withdrawals.
If you're making nondeductible IRA contributions, you should file Form 8606 with your tax return to report your contributions. That's important because when you begin making withdrawals, you can subtract those contributions from your pre-tax balance. For example, if over the years you've contributed $20,000 to a nondeductible traditional IRA and your balance is $100,000, you would only owe tax on the earnings, which would be $80,000.
If you have multiple IRAs, it can get complicated. The bottom line is that you can't pick and choose which IRA assets to convert and report to the IRS; you need to aggregate all of your IRAs for purposes of determining the taxable portion of your conversion.
16. What's the "5-year holding period" I've heard about?
If you're under age 59½ and you convert to a Roth IRA, you'll be subject to a 10% IRS penalty if you withdraw those assets within the first 5 years from the conversion unless an exception applies (such as disability). A separate five-year holding period applies to each conversion.
17. Can I get around the income restrictions on Roth IRA conversions by making a nondeductible IRA contribution and then immediately converting it to a Roth?
Yes, if your income exceeds the limits for Roth contributions, you could make a nondeductible traditional IRA contribution and then immediately convert into a Roth IRA. Since you'd have little or no gains—no profit—there's likely no tax to pay. But remember that the IRS rules for aggregating IRA balances still apply. If you have pre-tax IRAs that aren't being converted, all of your IRA balances must be aggregated when determining your tax obligation.
18. Can a Roth conversion count as part of my annual required minimum distribution?
With a traditional IRA, you have to begin taking annual required minimum distributions (RMDs) at age 70½. A Roth IRA conversion does not satisfy your RMD requirement. If you're planning to do a conversion, your RMD must be taken before (or at the time of) the conversion.
19. If I pay taxes quarterly, do I have to report my Roth conversion income quarterly as well?
Many taxpayers pay their income taxes throughout the year via paycheck withholding. But if you're self-employed, for example, you're probably making estimated tax payments on a quarterly basis.
If you're doing a Roth conversion, you'd certainly want to think about whether the resulting income needs to be factored into your quarterly payments. If you meet the IRS's "safe harbor" guidelines, you may not need to increase your quarterly payments. IRS Publication 505 (available from IRS.gov) is a good resource, or you could speak with a professional tax advisor.
20. What's the advantage of deferring the taxes from a 2010 conversion to 2011–2012, as opposed to doing two separate conversions in 2011 and 2012?
The main advantage of doing a conversion this year is that you'd get to start the possible tax-free growth in your Roth IRA now. If you delay until 2011 or 2012, you'd be missing out on that growth potential.
Another advantage is the ability to spread the resulting taxable income across 2011 and 2012. That's an option for this year only. In the future, under current law, you'll need to report any Roth conversion income in the year you make the conversion.
21. Are there differences between traditional IRAs and Roth IRAs in terms of investment strategy?
With any investment, you should always be aware of your asset allocation—that is, the mix of stocks, bonds, and cash in your portfolio. If you're investing for retirement and you have a long time frame, you'll probably want a significant allocation to stocks and stock funds, as they've historically had the highest potential for long-term growth. And that's true whether you're investing in a traditional IRA or a Roth.
Something else you should consider is asset location. As a rule of thumb, you may want to consider locating your tax-efficient investments (such as broad-market stock funds or municipal bond funds) in taxable accounts, and your tax-inefficient investments (such as taxable bond funds or actively managed stock funds) in tax-advantaged accounts like IRAs.
If you have a long time frame, and your portfolio has different account types—and if your goal is to defer or eliminate taxes—the asset location decision is particularly important.
22. If I convert to a Roth IRA and then the stock market declines over the course of the year, can I reverse my conversion? If so, when can I convert back to a Roth?
You can undo a Roth conversion through what's called a recharacterization, in which the amount of the conversion—plus any earnings or losses—goes back into a traditional IRA. This can be an option for several scenarios: for example, if your tax liability is greater than you expected, or if you don't have the funds to pay the conversion tax, or if the market declines and you want to later reconvert with the hope of minimizing your tax obligation on the conversion.
Provided you file your tax return on time, you have until October 15 of the following year to recharacterize a Roth conversion. If you're planning to reconvert to a Roth later on, it's important to remember that there's a holding-period requirement. You have to wait 30 days after the recharacterization or until the beginning of the next calendar year after the original conversion, whichever is longer.
23. What are the estate planning implications of a Roth IRA conversion?
One of the benefits of converting to a Roth IRA is that your heirs will not need to pay income taxes on their distributions after you're gone, which isn't the case with a traditional IRA. This can be especially helpful if your beneficiaries are in a higher tax bracket.
Although currently there's no federal estate tax for the year 2010, there are proposals to reinstate it—possibly retroactively. So it's important to understand that your IRA assets, whether traditional or Roth, would be considered part of your estate, and thus may be subject to estate taxes. And in the case of a traditional IRA, your beneficiaries could be taxed twice—first with estate taxes, and then on the distributions from the IRA.
24. Could income from a Roth IRA conversion trigger the alternative minimum tax?
The alternative minimum tax, or AMT, is basically a parallel tax structure that was designed to keep the wealthiest Americans from using certain deductions and credits to avoid paying taxes. In recent years, it has affected more and more middle-income taxpayers because the amount of income that can be excluded from AMT hasn't been indexed for inflation.
Because any taxable income a Roth conversion produces is considered ordinary income, there's no preferential tax treatment, and so, generally speaking, it may not trigger AMT. If you're subject to AMT, you may want to discuss this with your accountant.
25. I'm retired and have begun using the money from my IRAs. About half of my portfolio is in traditional IRAs, and the other half is in Roth IRAs. Should I think about converting more to a Roth?
Having assets in both types of IRAs can be beneficial in terms of tax diversification, giving you flexibility in deciding which account to tap tax-efficiently. Also, a Roth conversion would likely result in a tax liability, so you'll want to think carefully before converting any remaining traditional IRA assets since you are currently spending from the IRA.
26. I have money in a 401(k) as well as in a traditional IRA. Can I move all of this money into a Roth IRA at once, or do I need to do a traditional IRA rollover from my 401(k) first?
You can do a direct rollover from an employer-sponsored plan into a Roth IRA, or you could roll the money into a traditional IRA and then convert part or all to a Roth.
The IRS aggregation rules for determining a converted IRA's taxable basis don't factor in assets in non-Roth 401(k)s and other employer-sponsored plans. However, if you first roll your 401(k) into a traditional IRA and then convert that traditional IRA to a Roth, your rolled-over 401(k) assets must be included with all of your IRA assets for the purpose of calculating how the Roth conversion is to be taxed. So, if you're thinking about rolling over accounts that were funded with after-tax contributions, think carefully about the timing and the potential tax impact.
If your employer-sponsored plans have been funded with any after-tax contributions, it's a good idea to talk to a tax professional before completing the rollover.
27. Can a SEP-IRA be converted into a Roth IRA?
Yes. The IRS allows you to convert the following accounts to a Roth IRA:
Traditional IRAs.
Simplified Employee Pension (SEP) IRAs.
Savings Incentive Match Plan for Employees (SIMPLE) IRAs. (Note: SIMPLE IRAs may not be converted during the first two years of participation.)
Salary Reduction Simplified Employee Pension Plans (SARSEP).
28. Can I convert my 401(k) savings into a Roth 401(k)?
Not at this time. If your employer offers a Roth 401(k), however, you may want to consider it for your future contributions.
29. I have a nondeductible traditional IRA that has lost money over time. Can I claim a loss if I convert to a Roth IRA?
Generally, losses within IRAs are not deductible. However, if you have an IRA that was funded with nondeductible contributions—and the value of the IRA has dipped below the value of the contributions—you may be able to claim a loss as a miscellaneous deduction (subject to 2% limit on your adjusted gross income), but all of your IRAs must be converted. You'll probably want to speak with a professional tax advisor first.
30. Can I use long-term capital losses to reduce taxes I owe on a Roth conversion?
You can offset gains and losses in a taxable account in a particular year, but if your losses exceed gains, then you can carry forward the losses. This loss carry-forward can offset your income—including Roth conversion income, as well as wages, interest, etc.—up to $3,000 in a particular year.
31. I'm 68 and retired. Would it make sense to convert some of my traditional IRA to a Roth to lower my RMD when I turn 70½, or is it too late?
A Roth conversion—even a partial conversion—will reduce the value of your traditional IRA, and thus lower your future RMDs. That can be beneficial if you don't need your RMDs for current income and hope to pass along this money to your heirs. But if you expect to need your IRA assets during retirement, conversion may not be a good idea because of the immediate tax liability.
If you're already taking RMDs, remember that a Roth conversion doesn't satisfy your RMD requirement. Your RMD must be taken before (or at the time of) the conversion. Also note that there could be an impact on the way your Social Security benefits are taxed (see question 32).
32. Can a Roth conversion affect my Social Security benefits and Medicare premiums?
Yes. First, let's look at Social Security. A Roth conversion could mean a one-year increase in the portion of your benefits that may be taxable. A Roth conversion will raise your total income (for Social Security purposes, defined as half of your benefits plus any other income, including tax-exempt income), and it's this income level that determines what percentage of your benefits are taxable (0%, 50%, or 85%). But keep in mind that distributions from a Roth won't affect the taxation of your Social Security benefits, and that may help you in the long run.
Medicare premiums work a little differently. Premiums are based on one's modified adjusted gross income (MAGI) from two years prior, which means your 2010 premiums are based on your 2008 MAGI. Since a Roth conversion this year will increase your 2010 MAGI (if the income is reported this year), your Medicare premiums might rise in 2012.
It's worth noting that most taxpayers pay the standard Medicare Part B premium—about 25% of the total cost, with the government paying the rest. If your MAGI exceeds certain levels, your premium will likely be higher. |
