Roth IRA Conversion Mistakes Can Be Costly

Roth IRAs have experienced a spike in popularity over the past decade. Between 2000 and 2009, the number of households owning Roth IRAs increased by an average of 6.3% per year, the fastest-growing rate of ownership among all types of IRAs.¹

What distinguishes a Roth IRA from other types of IRAs — and what may be responsible for its rise in popularity — is its ability to provide a tax-free income in retirement and its exemption from required minimum distribution rules.

Although contributions to a Roth IRA are made with after-tax dollars (income eligibility limits apply), qualified distributions are free of federal income tax as long as all conditions are met and regardless of how much growth the account experiences (under current tax law).

One popular way to fund a Roth IRA is by transferring assets from a traditional IRA or an employer-sponsored retirement plan. This type of transaction, called a Roth IRA conversion, is simple in theory but can be complicated in practice. If you make any of these mistakes, you could lose some key advantages.

Paying the conversion taxes with funds from the account you are converting. When tax-deferred assets are converted to a Roth IRA, you must report them as income on your tax return for the year in which the conversion takes place and pay the taxes owed.

Unless you’re older than 59½, it’s generally not advisable to pay the income taxes using money from the account you are converting. Withdrawing money from a tax-deferred plan to pay the conversion taxes before age 59½ would be considered an early distribution and thus may be subject to a 10% early-withdrawal penalty. Consider paying the taxes from a non-tax-deferred account.

Even if you are older than 59½, it could take years before the conversion begins to pay off. If you use some of the tax-deferred assets you are converting to pay the income taxes, you are reducing the amount of money available to pursue potential investment returns.

Failing to consider a “recharacterization” if the account loses value. If the value of the converted assets declines after the conversion, you may be able to “undo” the conversion using a process called recharacterization. This enables you to amend your tax return and obtain a refund of the conversion taxes that you paid. The deadline to recharacterize is October 15 of the year after the year in which the original Roth IRA conversion took place.

You can reconvert the assets to a Roth IRA later at the presumably lower value (which may result in a smaller tax liability) as long as you wait 30 days after the recharacterization date or until the calendar year following the year in which you made the initial Roth IRA conversion, whichever is longer.

Violating the five-year rule. To qualify for a tax-free and penalty-free distribution of earnings and converted assets, Roth IRA distributions must meet the five-year holding requirement and take place after age 59½ or result from the owner’s death, disability, or a first-time home purchase ($10,000 lifetime maximum). The rules governing the five-year holding requirement for converted assets are complex. Before you take any specific action, be sure to consult with your tax professional.

1) Investment Company Institute, 2010

The information in this article is not intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Emerald. © 2011 Emerald Connect, Inc.