FinancialEdge.net

1. What is a Roth IRA?
2. Roth Conversion.  Should You Convert to A Roth?
3. The Back Door Roth Conversion.
4. Changing Your Mind (recharacterization)
5. Steps to undo a Roth IRA conversion
6. Ordering and Potential Tax and Penalties on withdraws
7. Further Reading

1 What is a Roth IRA?

A Roth IRA is a retirement plan where the contributions are not tax deductible and qualified distributions are tax free.

A qualified distribution is one that is taken at least five years after the taxpayer establishes his or her first Roth IRA and when he or she is age 59.5, disabled, using the withdrawal to purchase a first home (limit $10,000), or deceased (in which case the beneficiary collects).

Non-qualified distributions from a Roth IRA may be subject to a penalty upon withdrawal.

RMD.  In a traditional IRA, required minimum distributions (RMD) are required beginning at age 70 1/2.  RMD are not required for Roth IRAs.

2 Roth Conversion.  Should You Convert to A Roth?

2.1. Can you afford to pay the tax on the conversion with outside funds?  Should you need to take out money out to pay the tax, you could be subject to a 10% penalty.

2.2. Do you expect to be in a higher tax bracket in the future?  If yes, then it makes sense to convert and avoid higher taxes in latter years.

2.3. When you plan to keep the money invested for a long time.  The longer you keep the money in the account, the more you can benefit from tax-free growth.  If you’re 25 years old it is possible that you will not need the money for another 40 years.

2.4. If you’re 60 years old, it may be OK to convert if you don’t need the money for another 10 to 20 years.  A malor advantage of a Roth is that you don’t have to start taking “required minimum distributions”.  In a traditional IRA you must take distribution once you turn 70 ½,.

2.5. You plan to leave the money to your children or beneficiaries. Non-spousal beneficiaries who inherit an IRA have to pay taxes on the mandatory annual distributions; with a Roth, annual distributions are a must, but they are tax-free.

3 The Back Door Roth Conversion.

For 2011 you can contribute to both a traditional IRA and a Roth IRA as long as the combine contributions do not exceed theto $5,000 maximum (or $6,000 if you’re age 50 or older by the end of the year).  These contributions are available as long as one of the spouse is working.  For the self-employed (e.g. Schedule C) there are other retirement plans which would provide you with higher contribution limitations (e.g. solo 401(k)).

For Roth, there is an additional test.  For 2011 you are eligible to contribute to a Roth IRA if your modified adjusted gross income is $122,000 or less if you’re single, or $177,000 or less if you’re married filing jointly.  To get around this limitation, you can contribute to a traditional IRA and then convert it to a Roth in the following year.

4. Changing Your Mind (recharacterization)

There are several reasons that one wants to undo the conversion:

• You don’t have non-IRA funds to pay the conversion tax.
• You will more likely be paying taxes at a lower “combine” federal and state tax rate upon retirement.  This is easy to control by moving from a high tax state to one without a state income tax. [see separate blog]
• The value of your investments declined following a conversion.
• You will not need the money and plan to leave a substantial amount to charity. It is generally more tax-efficient asset to contribute a traditional IRA to charity at death. Charities do not pay income tax, and the contribution will be excluded from your taxable estate.
• Your child be applying for college financial aid and a Roth conversion would increase your taxable income for the year.  The conversion should be deferred so it does not negatively affect your child’s ability to qualify for financial aid.
• The conversion will subject you to the alternative minimum tax.
• The conversion will result trigger a surcharge for his Medicare Part B coverage.

5.  Steps to undo a Roth IRA conversion.

You have six months from the due date to recharacterized (generally Oct 15th).

• Determine the amount that you wish to recharacterized.
• With a partial recharacterization select the assets to recharacterized.  For assets, such as stocks and mutual funds, make sure that the market value of the shares amounts that are recharacterized is equivalent to the ‘Conversion amount which is being recharacterized plus net income attributable (NIA)’.  [NIA, see separate blog]
• Contact your IRA administrator and ask to recharacterize the account back to a traditional IRA.  The administrators are generally firms such as Fidelity, Schwab, TD Ameritrade, TR Price.
• File Form 8606, Nondeductible IRAs.
• If you have already paid the tax bill, file an amended return, Form 1040X, to get a refund.

6 Ordering and Potential Tax and Penalties on withdraws

The IRS assumes that the first money withdrawn first comes from annual contributions you made, next from converted amounts, and finally earnings.  Contributions have been tax upon conversion and can be withdrawn at anytime penalty-free.  The converted amounts are always tax-free.  They are also penalty-free if you are older than 59 1/2 or the account has been open for at least five years. Finally the earnings are tax- and penalty-free after five years.

7 Further Reading:

• Computation of Net income attributable (NIA)
• Best Investment for traditional IRA and Roth IRA
• IRS Publication 590, Individual Retirement Arrangements.
• Form 8606, Nondeductible IRAs.
• Form 1040X

Success always begins with a plan.   I’m here to help.  Call me today at 415.967.EDGE or e-mail me at paulsid@financialedge.net.

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