New Ira Conversion Rules Should You Convert Your Traditional Ira to a Roth Ira

Beginning in 2010, new IRS regulations have made it possible for anyone to convert a traditional IRA to a Roth IRA. Learn what the tax implications are and whether converting would be beneficial to you.

Individual retirement accounts come in two primary forms: a traditional IRA and a Roth IRA. The traditional IRA allows you to make tax-deductible contributions while contributions to a Roth IRA are made with after-tax dollars and enjoy tax-deferred growth. Beginning in 2010, the IRS regulations governing the conversion of traditional IRAs to Roth IRAs will be expanded, allowing approximately fifteen million taxpayers to convert their traditional retirement accounts and enjoy the tax advantages of a Roth IRA. If you currently have retirement savings in a traditional IRA, there are several things to consider to determine if conversion to a Roth IRA is right for you.

Eligibility

Under the previous rules, taxpayers with a Modified Adjusted Gross Income of more than $100,000 or married taxpayers filing separately were prohibited from converting their traditional IRA. The new IRS rules eliminate the restrictions on income and filing status, making it possible for anyone with a traditional IRA to convert. The new rules also make it possible to convert funds from an employer-sponsored retirement plan, such as a Simple IRA.

Guidelines

Funds may be withdrawn from your traditional IRA and reinvested into an existing or new Roth IRA within sixty days without incurring the ten percent early withdrawal penalty. Contributions to a traditional IRA may be either deductible or nondeductible and the nature of the funds in the account will affect taxation, as each type of contribution is treated differently by the IRS. If you have made both deductible and nondeductible contributions to a traditional IRA, the IRS considers these funds as an aggregate of both pre-tax and after-tax dollars.

Taxation

Conversions are treated as income by the IRS and must be reported on your tax returns as such. What this means is that while you avoid the ten percent early withdrawal penalty, you still have to pay regular income taxes on the converted funds according to your correlating tax bracket. While you can pay the taxes from the money in your IRA, it makes more sense to pay the taxes out of pocket because if you use your retirement funds to pay, those funds cannot be replenished because of the annual contribution limits the IRS places on these types of accounts. The IRS is making a concession for IRA conversions that occur in 2010, in that they will allow taxpayers to split the tax liability onto the next two consecutive tax years, 2011 and 2012.

Considerations

Before executing an IRA conversion, you must first consider the tax implications of doing so. You must calculate an estimate of the amount of taxes you will have to pay for the conversion and how you plan to pay. If you do not have the cash on hand to cover the tax liability, then a conversion may not be right for you. Additionally, if you think you may be in a higher income tax bracket in the years immediately following the conversion, then you may end up paying even more in taxes.

The new IRS rules for IRA conversions are intended to help taxpayers who were previously unable to convert enjoy the tax advantages of a Roth IRA. To determine if a conversion is right for you, you must weigh the immediate tax implications of conversion against the future tax benefit of contributing to a Roth IRA.

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