The difference between your rollover IRA or Roth IRA is that instead of a tax deduction for your contribution, you get tax-free distributions later. It’s important to understand that if your tax rate stays the same, it doesn’t make a penny’s difference to your retirement income picture whether you use a traditional or Roth IRA rollover. Your net or after-tax income on withdrawals will be the same in either case.

If your tax rate goes up when you distribute your IRA rollover account later after retirement, you will be happy. Many believe that the current low tax rate is not sustainable—at least you wouldn’t want to be the farm that it is. Having an IRA rollover account for at least part of your retirement investments plan, hedges against possible tax increases later.

Another great use for a Roth IRA rollover is for young people who haven’t reached their full income potential. At low income tax rates, the value of the tax deduction given up by using a Roth IRA is negligible. Later, when they withdraw the funds tax-free that would have otherwise been taxed at a high rate, they will receive substantial tax benefits. In essence, they would have leveraged the tax code by the amount of the difference in their contribution and withdrawal tax rates. That’s very powerful. For instance, if you are in a 15% tax bracket now, the value of a $1,000 tax deduction is only $150. Let’s say that over time, your Roth IRA grows to $5,000. If you forgo the tax deduction and opt for the Roth IRA, when you take it out after retirement, you keep the entire $5,000 no matter how high your current tax bracket. If you had taken advantage of the Regular rollover IRA’s tax benefits, you would have saved $150, but you would be faced with tax on the entire $5,000 when you withdraw it. So the amount in your hands after tax would be far less.

Roth IRAs offer some benefits for your estate. In essence, you have prepaid the income tax on the entire amount for your heirs. The ability to stretch the tax-free distributions across at least two generations is very powerful. Additionally, there are no forced withdrawals at age 59.5. These advantages may or may not be an important issue for you, but it’s an added benefits.

Contributions of Rollover IRA to a Roth IRA can always be withdrawn tax free. But, the earnings must remain in the account until the account holder reaches age 59.5, or five years after deposit—whichever is later—to receive tax-free treatment.

The ability to withdraw contributions tax-free makes them a great way to accomplish multiple goals in a tax-preferred manner. Suppose, for example, after a number of years of contributions, you withdrew those contributions to fund your daughter’s college education while leaving the earnings to compound tax-free for your later retirement.

For a withdrawal from a Roth IRA to be considered qualified, meaning that you avoid taxes and penalties on the withdrawal, you must meet certain conditions.  A five-year aging requirement is imposed by the IRS, and you must meet one of three additional conditions – you must be at least 59 ½ years old, you must be making a first time home purchase, or there must be a disability or death to you or a dependent.  If you fail to meet these qualifications, taxes must be paid on the earnings withdrawn, in addition to a 10 percent additional tax penalty unless you qualify for an exception according to IRS rules.

While traditional IRAs require you to receive required minimum distributions (RMDs) beginning at age 70 ½, there’s no such requirement with Roth IRAs, except for Roth 401k plans.  As with a traditional IRA, you must begin receiving RMDs from a Roth 401k at age 70 ½ years.  As an additional precaution, be aware that contributions to a Roth 401k IRA cannot be moved to a regular 401k account, as you can’t “un-pay” taxes on the funds in your Roth account.

To continue to reap the benefits of your Roth IRA, consider carefully where and how any withdrawals will be used before they’re removed from your account.  As noted above, there are certain taxes and fees involved with a withdrawal which may make a rollover more advantageous.

Because of the nature of the funds in a Roth IRA, they can only be rolled over into another Roth IRA.  Generally, you would only move funds from one Roth IRA to another Roth IRA if the second offered you some advantage, such as increased earning potential, more control over your money or the ability to consolidate accounts under one provider or adviser, for example.

The rules surrounding Roth IRAs are a little different and a little more complex than traditional IRAs, especially with the legal changes that take effect in the 2010 tax year.  With this knowledge, you may want to consult a tax adviser or your financial planner before you make any decisions about moving money from one Roth IRA to another, or before you consider making a withdrawal.  There may be good reasons for either transaction, but you should confirm your decision with someone better versed in Roth IRA rules before you make decisions that could impact your future and that of your family.

Prior to 2010, your ability to convert funds to a Roth IRA was restricted by many things, including your tax filing status.  If you were married but filing separately, for example, you had to be separated from your spouse for an entire year in order to be eligible.  Now, however, there’s no longer a rule prohibiting people who are married but filing separately from converting their accounts.  If you have recently divorced or are in the process of filing for divorce, it makes sense to talk to a financial planner about saving for your retirement, as well as providing for any children or beneficiaries you may have.

Your adjusted gross income was also a factor in Roth IRA conversions before 2010; you weren’t eligible for a conversion if your modified adjusted gross income was more than $100,000.  As of 2010, this income limit no longer applies.  However, bear in mind that this repealed restriction applies only to Roth IRA conversions – traditional income restrictions still apply to future contributions made to Roth accounts.

In addition, while the IRS used to place limitations on the types of IRAs that could be converted into Roth IRAs, this has now changed – with a few exceptions.  A Simple IRA can be converted to a Roth IRA after you’ve been a participant in the Simple IRA for a minimum of two years, while designated Roth IRAs still cannot be converted to Roth IRAs.  Besides these two distinctions, your IRA should be eligible for rollover and/or conversion to a Roth IRA.

The most important thing to keep in mind when you’re considering a rollover IRA/Roth IRA conversion is taxes.  You see, the money in your IRA is money you’ve earned – either as income or interest – but that you haven’t yet paid any federal or state income tax.  Money in a Roth IRA, on the other hand, is money that has already been taxed.  This means that if you rollover your IRA into a Roth IRA or convert your IRA to a Roth IRA, you’ll have to pay taxes on the portion converted.

The fact that you’ll owe taxes if you rollover or convert your money to a Roth IRA was previously seen as a disadvantage by those who would otherwise be ideal candidates for Roth accounts.   However, many participants are beginning to seeing the advantage of paying taxes now, in anticipation of tax rate increases later in life.  There’s also the advantage of paying taxes now, rather than leaving that burden for the inheritors of your estate.  Your tax accountant or financial planner can help you to understand the tax implications of an IRA rollover/Roth conversion and to decide if it makes good financial sense for you.

In fact, any time you’re considering a Roth IRA rollover, it makes sense to meet with your tax accountant and financial planner and review your financial goals, particularly because IRA rollover questions usually arise when you’re changing jobs.  Any time you make a major financial change, it’s a good time to step back and reassess your retirement savings goals.

First, you cannot rollover funds from a Roth IRA into a traditionally structured IRA – you can only roll them over to another Roth IRA.  If you think about it, this makes logical sense – one of the reasons to have a traditionally structured IRA is to defer taxes on that portion of your income, a benefit you’ve lost already if the money is in a Roth IRA.  You can rollover funds from one Roth IRA to another Roth IRA if there is a compelling reason to do so, such as an opportunity to improve your investment portfolio’s management or returns.

You can also rollover funds from a traditionally structured IRA into a Roth IRA, but there will usually be taxes to be paid.  Legislative changes for the 2010 tax year are making it more advantageous to have a Roth IRA conversion account.  However, before you change the way your investments are structured, it’s a good idea to review your short and long term financial plans with a tax or financial adviser.  It may be beneficial for some individuals to pay those taxes upfront and convert money into a Roth IRA, but not for all.  Professional advice can help you to be certain where you stand before you initiate such a transaction.

One advantage of Roth IRAs is that having already paid taxes on the money you contributed, there are generally no taxes paid on withdrawals so long as they are considered qualified withdrawals or distributions.  To be considered a qualified withdrawal, you must have been participating in the Roth IRA for a minimum of five years and you must be at least 59 ½ years old.  However, if you’re buying your first home, become disabled, or are using your Roth IRA money to pay for higher education, then your distribution may be considered qualified without meeting those two criteria.  Withdrawals or distributions that are deemed not qualified may be termed early withdrawals, upon which the IRS imposes a 10 percent tax penalty.

One rule you should be aware of is that if you attempt to rollover your funds to a Roth IRA and are unsuccessful for some reason, you may also be subject to early withdrawal penalties.  Generally, speaking with the trustee or manager of the target Roth IRA will ensure that the Roth IRA is ready and able to accept any rollovers.  In fact, not having an account which is ready and able to receive funds is one of the most common Roth IRA rollover mistakes.

There is a wealth of information regarding Roth IRA tax rules located on the IRS website.  You may also be able to find IRS publications at your local post office or public library.  If you need help understanding the rules surrounding Roth IRA accounts and rollovers, talk with your tax adviser or financial planner.  When it comes to your future and your money, it’s a step well worth taking.

Step 1 – Open a Roth IRA

If you’re at this point in the process, you’ve already rolled your old employer’s 401k or 403b retirement funds into an traditional rollover IRA account, which means you’ve already done the hard work of choosing an IRA account provider and moving your funds out of their original plans.

In most cases, you’ll want to open your Roth IRA account with the same provider that holds your rollover IRA.  This is the easiest course of action, although you may want to change providers if you’ve been unhappy with the customer service or investment options at your current provider.

Whether you decide to stick with your old provider or choose a new one, your first step in the Rollover IRA/Roth IRA conversion process is to open a Roth IRA account.  Typically, all you’ll need to do is fill out a form with your personal information – the provider will take care of the rest.

Step 2 – Fill out the Conversion Paperwork

If you decide to stay with the same IRA account provider, you’ll need to fill out a form they provide that details how the conversion will occur.  You’ll use this form to let the provider know how much of your funds should be converted and whether or not you’d like the provider to withhold any tax from the transfer.  You’ll likely need to have this document notarized and sign your name to indicate that you’ll be liable for the Roth IRA tax.

If you choose to open your account with a new provider, your paperwork may be a little more complicated, since you’ll need to transfer your funds between providers and from a traditional IRA to a Roth IRA.  However, it shouldn’t be that much more complicated than the documentation you completed to move your funds from the original 401k account to your rollover IRA.  If you have any questions, a customer service representative should be able to help walk you through the process.

Step 3 – Select Your Roth IRA Investments

Once you’ve completed the necessary paperwork, your provider will handle the rest of the transaction.  The Roth IRA transfer will take anywhere from a few hours to a week or two, depending on your provider.  After the funds have been deposited into your Roth IRA account, you’ll need to choose your investment options, just as you did with your 401k and rollover IRA accounts in the past.  A qualified financial advisor can assist you if you aren’t sure which options to choose.

In the future, when it comes time to pay taxes on your Roth IRA conversion, you’ll need to watch for mailed statements from your account provider.  Typically, you’ll receive a Form 1099R which shows how much money was converted to your Roth IRA.  This will need to be included on your annual income taxes; otherwise, you could face serious Roth IRA penalties.

Many taxpayers consider the option to rollover their traditional IRA to a Roth IRA in order to convert money that grows tax deferred to tax free. This conversion can produce large tax savings over the long run — over $100,000 in some cases.

                           Roth IRA    Regular IRA
Balance Today              $300,000    $300,000
Balance in 20 years        $962,140    $962,140
Tax Due                           0    $317,506
Add back                               $219,112
Value after tax and
add back                   $962,140    $863,746
Tax Free Growth                YES         NO

Assumptions: IRA owner age 65 grows IRA for 20 years until death.  Mandatory distributions taken from other IRA funds so unencumbered growth occurs in regular IRA.  All funds earn 6%, combined tax rate of 33%.  Roth IRA conversion tax is paid from non-IRA funds.  The “add back” in the above table is the future value of the tax dollars saved (taxes that don’t need to be paid) if the Roth IRA conversion is not done and the regular IRA is retained.

Yet for others, the Roth rollover may not pay. It’s important to understand the following rollover issues before deciding whether to do an IRA to Roth IRA conversion which we cover in this article.

Why Consummate an Rollover IRA to Roth IRA Conversion?

* Your Roth IRA will grow to a larger amount than your regular IRA even if it contains the same number of dollars. The reason is that the Roth IRA contains after-tax dollars. In a traditional IRA, some of the earnings will eventually go to the government in the form of income tax, but in a Roth IRA you get to keep everything. A bigger balance means bigger cash flow in retirement.

* You can keep your money in a Roth IRA for a longer period of time. There is no requirement for minimum distributions to begin when you reach age 70½. Keeping money in an Rollover IRA for a longer period of time means extending the period of tax-free compounding.  Again, a bigger balance means more cash flow in retirement.

* If you’re wealthy enough have a potential estate tax liability, rolling over to a Roth IRA may reduce that liability. If you die holding a regular IRA, the entire IRA may be included in your estate even though part of it will end up going to the IRS as income tax (and estate tax) when your beneficiaries take distributions. In the case of a Roth IRA, you have already paid the income tax, so your estate is smaller even though you are effectively passing the same amount of wealth to your heirs.

There’s a special added benefit if you have a significant amount of basis in your regular IRA — in other words, if you made nondeductible contributions to your regular IRA. When you rollover your regular IRA to a Roth IRA, the portion of the rollover that comes from nondeductible contributions is tax-free, i.e. you pay no tax on these funds as you already paid tax on these after-tax dollars. Yet you are moving that money from a place where the earnings will be taxable eventually to a place where the earnings will be entirely free from tax. You should strongly consider a rollover if you’ve made nondeductible contributions to your regular IRA. Note, however, that you’re not permitted to roll over only the tax-free portion of your regular IRA. Any distribution you take from your regular IRA, including a rollover distribution, comes partly from your nondeductible contributions and partly from other amounts (deductible contributions and earnings) that are in your IRA.

The Big Consideration–The Tax Due Now

The conversion to a Roth IRA so far sounds good but what stops most taxpayers is that they must pay tax on any of the pre-tax dollars rollover to a Roth IRA.  No one likes finding money to pay tax. The important question to ask when considering a rollover to a Roth IRA is: where will you get the money to pay the tax? If you have the money readily available (e.g. in a savings account)— without using any of the money that’s now sitting in your IRA — you’re in good shape to consider a rollover. However, if you don’t have funds to pay the tax and you need to use IRA money to pay taxes on the rollover, the rollover is not for you as you will defeat the benefits. This is a factor indicating that you shouldn’t do the rollover unless you’ve done a thorough analysis and understand the benefits and detriments thoroughly.

Tax Brackets and Partial Conversions

These are the tax brackets for 2010 for married and single taxpayers.

Federal Income Tax Brackets For 2010 – Based On Taxable Income Ranges

Tax Rate Married Filing Jointly  Most Single Filers
10%     Not over $16,750         Not over $8,375
15%     $16,750 – $68,000        $8,375 – $34,000
25%     $68,000 – $137,300       $34,000 – $82,400
28%     $137,300 – $209,250      $82,400 – $171,850
33%     $209,250 – $373,650      $171,850 – $373,650
35%     Over $373,650            Over $373,650

Another important question to ask is how tax brackets will affect the rollover. Try to estimate what tax rate will apply to your IRA when you withdraw the money in retirement or otherwise. If you expect to pay only 15% on most or all of your IRA distributions when you make distributions in retirement, you should avoid paying 25% or more today on your rollover unless it is strongly justified.

If you’re in the 25% tax bracket (or higher) now, and know you’ll be in the 15% bracket when you retire, there’s little you can do about this factor. You may want to consider preparing a detailed projection (or having a tax professional do so) to see if you can still benefit from the rollover. Unless your situation is unusual in some way, you’ll probably find that there’s little or no benefit in making the Roth IRA rollover.

Some people will find that although they’re in the 15% tax bracket now, the rollover itself will push them into a higher  tax bracket making the Roth IRA conversion uneconomical. If this is your situation, you should consider rollover part of your IRA to a Roth IRA. If you convert just a portion each year, this may keep your tax bracket down and minimize your conversion tax.

Case Study

Bill and Linda are both retired, have large IRAs, and are age 60.  Their taxable income will be $30,000 this year.

The tax law extends the 15% tax bracket for married couples filing jointly to $68,000 (see table above).  Thus, Bill and Linda could convert $38,000 worth of their IRAs to Roth IRAs this year and fully use up their 15% tax bracket.

The federal income tax rate on the $38,000 conversion will be 15% ($5,700).  And after Bill and Linda hold the Roth IRAs for five years, they can withdraw the money tax-free.  Each year they will repeat the process and continually shift a large portion of their IRA to a Roth.  By doing partial conversions each year, they never push themselves into a tax bracket higher than 15%.

If Bill and Linda had waited until they were 70 ½ and subject to required minimum distributions, the withdrawals may have pushed them into a higher marginal tax bracket or tax brackets may be higher due to federal deficits.

If retirement is many years away (say, 20 or more) you may choose to make the rollover even if it appears you may be incurring more tax now than you would in retirement. Twenty years is a long time in which to enjoy the benefits of the Roth IRA Rollover–the tax free compounding. If you take full advantage of those benefits by maximizing the amount you keep invested there, your gains may outweigh the tax cost of converting to a Roth IRA.

Finally, as explained above, a rollover to a Roth IRA provides a special bonus if you’ve made nondeductible contributions to your regular IRA. If a significant portion of your regular IRA is from nondeductible contributions you should consider a rollover even if it means paying tax at a higher rate on the portion of the rollover that’s taxable. In this situation, it may be necessary to prepare an income projection (or have one prepared by a tax professional) to determine what choice works out best.

Creditor Protection

Many states provide some measure of creditor protection to regular IRAs (although they aren’t necessarily completely insulated). For reasons having to do with the way state bankruptcy laws are written, there’s some question whether the same protections are available to Roth IRAs. If you have a reason to be concerned about creditor protection — for example, your debts are large or you engage in a high risk business or profession — you should consider this issue before you roll over a large amount from a regular IRA to a Roth IRA. And the issue is even more important if the money you’re planning to rollover to a Roth IRA is currently in an employer plan, protected by federal retirement law (ERISA) which gives you total creditor protection.
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