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The Ins and Outs of Roth IRA Conversions
If you are thinking about making a Roth IRA conversion in
2006, now is the time to make sure that distributions from your
traditional IRA are completed before year end. Yes, you have
until April 15, 2007 to make a 2006 contribution to your Roth
IRA, according to Ed Slott, publisher of Ed Slott's IRA Advisor,
but Roth IRA conversions work a bit differently. According to
Slott, the Roth IRA conversion will count for the year as long
as the funds are withdrawn from the traditional IRA before year
end. And that's true even if withdrawn funds are not contributed
to the Roth IRA until early in the following year.
It is important to note also that a Roth IRA conversion is
considered a rollover and thus the distribution from the
traditional IRA must be deposited to the Roth IRA within 60 days
of receiving the distribution. Otherwise, there's a penalty. To
avoid a penalty, Slott recommends that taxpayers convert their
funds to the Roth IRA in the same year as the distribution from
their traditional IRA. That way, all the tax reporting for the
year matches up. What's more, Slott advises taxpayers to use
what's called a direct rollover (a trustee-to-trustee transfer)
so they won't have to worry about the 60-day rule. With a direct
rollover, the funds in the traditional IRA are transferred
directly to the Roth IRA.
Why should taxpayers do a Roth IRA conversion before the end
of 2006? To be sure, taxpayers who qualify can convert any time
they want. In order to qualify for conversion of traditional IRA
funds to a Roth IRA, a taxpayer's Modified Adjusted Gross Income
(referred to by the IRS as "MAGI") cannot exceed
$100,000 and the taxpayer cannot file as married,
filing-separate. Of course, come 2010, the tax law will change
such that everyone will qualify for a Roth IRA conversion.
There are many reasons why a taxpayer might convert in 2006.
For instance, taxpayers who expect their income to be below
$100,000 this year but not in future years should consider a
2006 Roth IRA conversion. Slott also notes that taxpayers who
may be in a lower tax bracket this year than they expect to be
in the future will pay less tax on a conversion if it is done
this year. Just to be on the safe side, those who have already
done a Roth IRA conversion this year should double-check to make
sure the conversion funds actually were deposited into the Roth
IRA.
Taxpayers who qualify for MAGI and who are under age 59½
have another reason why they may want to convert this year.
Conversion starts what the IRS calls the five-year clock. Funds
put in a Roth IRA, even in December 2006, are viewed as being
deposited on January 1 of 2006 for purposes of the so-called
five-year requirement. According to "Ultimate IRA
Resource" by William Wagner, amounts distributed from a
Roth IRA are generally received tax-free if the distribution is
made more than five years after the creation of the Roth IRA and
the distribution occurs after the individual turns age 59½.
Other qualifying circumstances include the owner's death or
disability, or if the distribution is for a first-time home
purchase. Distributions that don't meet the requirements are,
according to Wagner, generally subject to an early distribution
penalty tax and includable in income, unless an exception
applies.
By converting now, taxpayers under age 59½ can start the
five-year clock running and increase the odds of being able to
make a penalty-free withdrawal from their Roth IRA. Slott
suggests that having tax- and penalty-free access to a Roth IRA
is a much better alternative than having to start a 72(t) payment
schedule in order to get penalty-free funds from an IRA before
reaching age 59½.
For example, funds converted to a Roth IRA in December 2006
are deemed converted as of January 1, 2006 and that starts the
5-year clock. Thus the five-year period will end on December 31,
2010.
To be sure, there are some taxpayers who don't know if they
will be eligible to convert or they may not even be sure if they
want to convert. Slott suggests that taxpayers have nothing to
lose and everything to gain by converting before year end. This
is because a Roth IRA conversion is one of the rare "second
chances" taxpayers receive under the tax code. Roth
conversions can be reversed or "recharacterized" up to
October 15 of the year after the conversion for any reason.
Thus, a 2006 Roth conversion can be recharacterized at any time
up to October 15, 2007.
Typically, Roth IRA conversions are recharacterized when a
taxpayer converts from a traditional IRA and the value of the
Roth IRA investment declines. According to Slott, taxpayers who
want or need to recharacterize their Roth IRA conversion should
deposit this year's converted funds to a new Roth IRA (separate
from any other Roth accounts they may have) until the time to
recharacterize has expired. Thus, if the investments decline in
value, the taxpayer can recharacterize just those investments
and not have to take any other Roth IRA funds into account.
Funds that commingled with an existing Roth IRA can complicate
the recharacterization.
Slott also recommends setting up separate Roth IRA accounts
that would contain similar types of investments. Thus, there
would be a separate Roth IRA for large-cap value stocks and one
for large-cap growth stocks and one for technology stocks and so
on. That way, the taxpayers can "cherry-pick" which
Roth IRAs to recharacterize. The taxpayer would recharacterize
the Roth IRAs that have declined in value and hold the Roth IRAs
that have gained in value. After the time to recharacterize
expires (October 15 of the next year), Slott notes that the
taxpayer can go back and consolidate all of the Roth IRA funds
remaining for that year in one Roth account.
December 2006 — This column is produced by the Financial
Planning Association, the membership organization for the
financial planning community, and is provided by Don McCarty of
Financial Decision Partners, a local member of the FPA.
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