IRA Conversion: Understanding the Issues & Tax Implications

An IRA conversion is the transfer of one type of IRA, either a Roth or a traditional one, into the other form. If you are changing your IRA to a 401k or other option, then you are actually rolling over the account, which has different rules. A conversion only applies if the money is staying in the same place, but the tax structure is changing. 

Tax Differences between Roth and Traditional Options

First, it is necessary to understand the difference between the way these two options are taxed. A traditional IRA is taxed in the original method offered by the IRS. An individual can place pre-tax dollars in the account. This means, in a given year, the amount you contribute to your IRA will be deducted from your taxable income. This reduces your liability in the current year. The money grows tax-free, and then you will pay taxes on the distributions you receive upon retirement at the tax bracket you fall into at that point in time.

The Roth option works somewhat oppositely. There is no tax break in the present; you will contribute post-tax dollars to the account. Then, the money grows tax-free just as with the traditional option. When you receive a distribution, you have already paid taxes on the funds, so you do not pay taxes at that point in the future.

Benefits of a Conversion

The Roth IRA option was created to encourage individuals at a low current income bracket to save money. The tax break in the present offers little to this type of individual. However, because the Roth allows this person to gain the tax break in the future, when he or she may be in a much higher tax bracket, there is a greater incentive to save. Therefore, a person who was using a traditional account may find there is more incentive to the Roth option, and this can create an ideal scenario for a conversion.

Conversion Tax

The most common complication with a conversion is the tax liability. The money you are moving out of the traditional option has not been taxed. Yet, you are placing this money into an account that requires post-tax dollars. Therefore, you must pay taxes in full on the account. Calculating this tax becomes very complicated. Only the non-Roth contributions to the traditional account must be taxed. This amount is calculated as a percentage of the total non-Roth IRA balance. Then, this percentage is applied to the amount that will be converted into the Roth IRA and added to the annual taxable income.

Issues with Conversion

Aside from being complicated, other issues can come up during a conversion. First, Roth IRAs have lower annual maximums than traditional IRAs. Therefore, you may not be able to convert all of your non-Roth contributions into a Roth account. Second, the IRS has attempted to make the process easier for conversion in the tax year 2010. If you are converting in 2010, you can distribute the taxes for the conversion over multiple tax years to decrease the burden. To understand what you must pay in a given year, you must consult a tax professional.