To take advantage of the opportunity to pay your taxes owed in two parts, you must request a direct rollover if your funds are being rolled over from a traditional IRA to a Roth IRA. A direct rollover is a transaction wherein your funds will be rollover directly between your current IRA and your target (or new) Roth IRA. You will never receive physical possession of the funds; if a check is issued, it will be paid directly to the trustee or manager of the Roth IRA account.
When you hear the phrase “tax law changes,” you probably aren’t expecting good news. However, if you’re considering a rollover IRA/Roth IRA conversion, these tax law changes may actually be to your advantage.
One of the biggest tax law changes in 2010, as far as traditional IRA/Roth IRA rollovers and conversions are concerned, is the ability to pay any Roth IRA tax incurred in 2010 during the conversion process in two parts. To take advantage of this benefit, you report half of the amount converted during 2011 and pay taxes on it in that year, and then report the remaining half of the account balance during the 2012 tax year. Spreading out the taxes over two years certainly helps to lessen the Roth IRA tax burden you’ll incur during the rollover/conversion process.
If for some reason the trustee of your current IRA is unable to perform a Roth IRA transfer, then the funds will have to be issued to you. If this happens to you, understand that you have a limited amount of time to get that money into the target Roth IRA (typically 60 days, according to IRS statutes). Fail to do so – even by one day – and the IRS will assume that you’ve simply withdrawn your money and will stick you with a variety of taxes and penalties. For this reason, it’s a good idea to inquire about a direct rollover with both your current IRA trustee and your target Roth IRA trustee to make sure that this type of transaction can occur.
Here’s another tax consideration to make if you’re contemplating an IRA/Roth IRA conversion or rollover – where will you get the money to pay the taxes that are due? Ideally, you’ll want to avoid using the money from your IRA to pay the taxes due, as this lessens the amount of money you have to invest. Remember, you’re counting on these funds to grow over time to support you once you reach retirement age.
However, does it make sense for you to use money from your savings? Will the money you lose in interest income by reducing the amount of your savings be offset by the gains of your money in the Roth IRA? This is a question that deserves careful consideration. Your tax accountant or financial adviser can help you put pencil to paper and come up with a real picture of just how much money is involved and how these decisions will impact your financial outlook, both in the short term and in the long term.