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Roth Conversion Definition
Are there special rules if you convert to a Roth IRA in 2011? Yes there are but to understand them you must first understand the mechanics of a Roth conversion. A Roth conversion takes traditional retirement assets and moves them into a tax-free structure. Traditional retirement assets include employer plans like 401k retirement plans as well as traditional IRA plans. The structure changes from a strictly tax-deferred structure into a tax-free one. The tax-deferred structure makes contributions that reduce annual income, thus reduce annual income taxes. The money grows without tax consequence. Normal distributions start at age 59 1/2. These distributions are added to income. Early distributions are added to income and penalized 10 percent by the IRS.
The Roth IRA structure takes earned income contributions, but does not reduce annual income thus does not reduce income taxes. Like the traditional structure, the Roth grows deferred. Normal distributions require owning the Roth for at least five years and until age 59 1/2. When you convert to Roth in 2011, future distributions are tax-free. The conversion simply takes the money from the traditional, pays the taxes on all pre-tax money in the account and re-structures it all to grow tax-free.
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2011 Rules and Regulations
In order to convert to Roth in 2011, you need to follow certain rules. Tax legislation and IRS regulations adjust the rules of conversions and other IRA requirements occasionally. For example, prior to 2010, there were income limits on who qualified for a Roth conversion. Those exceeding income limits were not permitted to convert. While this isn't the case for 2011, tax law may change in future years. Another provision in 2010 was the ability to pay the taxes over two years. Roth conversions in 2010 could split the converted value in half, paying half the income taxes in 2011 and the other half in 2012. The 2011 regulations require all income added to personal income taxes in 2012, paying all converted tax liabilities in one year. When converting, the traditional retirement plan sends you a 1099-R to determine the taxable portion. You record this amount when filing personal tax returns.
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The thought of tax-free income is very enticing to most investors. That being said, the Roth conversion is not for everyone. Consider your income now, the time you have before you retire and your anticipated total annual income when in retirement from all assets.
First, you need to be sure you can meet the five year rule. If you don't hold the converted money for at least five years, the earnings are still added to income and penalized 10 percent. This is true regardless of how old you are.
Second, if you are in an extremely high tax bracket right now, but anticipate dropping into a much lower tax bracket in retirement, a Roth conversion might cost you more in taxes than it would save you. For example, $100,000 converted at the 35 percent tax bracket is $35,000 in taxes. Assume you drop to a 15 percent tax bracket when you retire. The same $100,000 distributed is only $15,000. Even assuming this $100,000 bumped you to a 25 percent bracket, you are still saving money.
Then consider whether you are going to take all the money out at once. Most people take small distributions over time that don't have a significant effect on income tax brackets. Also, if you don't have the money from a non-IRA account to pay the taxes, it might not be worth performing the conversion.
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- The Wall Street Journal, Tax Changes For 2011: A Checklist : http://online.wsj.com/article/SB10001424052748703675904576063903166546250.html
- IRS Ordering Rules for Distributions: http://www.irs.gov/publications/p590/ch02.html#en_US_2010_publink1000231083
- Some old chinese people are making sport. Nanjing, China. via wikimediacommons.org/Stougard, December 13, 2008; Some old chinese people are making sport. Nanjing, China.