Roth IRA Conversion

The first thing you need to know about a Roth IRA conversion from a Traditional IRA account is that the eligibility rules were changed as of 2010.  Before 2010 anyone with an income over $100,000 was not allowed to do a Roth IRA conversion, however, this was changed so that anyone, regardless of their income, is allowed to convert.

Roth IRA Conversion TaxesRoth IRA Conversion

One of the most important changes of recent is that you must now pay income tax on the year’s income that you are converting from.  The reasoning for this is that you received tax deductions for Traditional IRA contributions, and must now pay taxes for your Roth IRA conversions so that your withdrawals in the future will be tax free.

Roth IRA Conversion Considerations

  • Take note of your expected income situation for the current and future years.  For example, if you have suffered an unexpected pay decrease in the current year you will pay less tax if you convert.  Conversely, if you expect to make more in future years, it makes sense to convert presently to avoid paying extra taxes in the future.
  • Always stay on top of tax laws and announcements.  If the government announces that there will be tax increases shortly in the future, you probably want to convert before that.  The opposite goes as well, if there are new tax breaks or cuts coming, wait for those if you are in no immediate hurry to convert.  Similarly, check every year for changes to contribution limits (i.e. for this year the Roth IRA Contribution Limits 2012).
  • Make sure you only pay tax on the Roth IRA conversion if you have to.  One common mistake is that people pay tax on previous after-tax contributions (where you have already paid taxes before depositing) to their old accounts, in most cases you only need to pay taxes once!
  • It doesn’t have to be one or the other between a Traditional IRA and Roth IRA.  There are no laws or rules that say you can only have one of these accounts.  It often makes sense for you to own both types of accounts for diversification purposes.  Depending on changes in your financial situation from year to year contributing to one may be better for you than the other; it is nice to have that flexibility.  There are many benefits of a Roth IRA conversion, keep them in mind when planning your finances.