Considering Converting Your Traditional IRA to a Roth IRA?

Julie Armstrong, CPA

Traditional IRAs allow most taxpayers to deduct contributions from taxable income in the year that they are funded.  Over time, all income and capital appreciation generated compounds tax free.  However, when future distributions are taken from a traditional IRA, they are generally fully taxable as ordinary income to the taxpayer.  Assuming the taxpayer and/or spouse of the taxpayer is not an active participant in a retirement plan maintained by an employer, a taxpayer may contribute up to $5,000 ($6,000 if age 50 or above) to a traditional IRA for 2011 with no income limits on the taxpayer.

Roth IRAs, on the other hand, do not allow a taxpayer to deduct contributions to the account.  Like traditional IRAs, all subsequent income and capital appreciation compounds tax free.  However, provided certain tests are met, all future distributions from a Roth IRA will be exempt from tax.  As with the traditional IRA, a taxpayer may contribute up to $5,000 ($6,000 if age 50 or above) for 2011, but the maximum yearly contribution that can be made to a Roth IRA is phased out for a single individual with modified adjusted gross income (MAGI) between $107,000 and $122,000 and for joint filers with modified AGI between $169,000 and $179,000 (income amounts are adjusted a bit higher for 2012).

Until 2010, only taxpayers with MAGI of less than $100,000 could convert a traditional IRA to a Roth IRA.  However, this limitation was repealed and virtually every taxpayer will be allowed to convert a traditional IRA to a Roth IRA.  For many high-income taxpayers, this provides a significant opportunity to move funds from a tax-deferred investment to a tax-free investment.


A taxpayer may convert all, or a portion, of a traditional IRA to a Roth, but conversion comes with a price!  A taxpayer must pay income tax on any amounts converted in the year of conversion.  However, due to the relatively low income tax rates in effect for 2011 and 2012, and the prospect of higher rates in the future, the cost to convert could make sense depending on your circumstances.  Things that should be considered are the number of years until withdrawals will be made, other income sources upon retirement, and current marginal tax rate.  A taxpayer has until December 31 of the year that they wish to convert to do so.

Once funds are converted and have met a five year holding period, the taxable conversion amount is available for withdrawal without additional taxes or penalties being imposed. Earnings on the conversion amount may be withdrawn without taxes or penalties upon reaching age 59 ½ or older, and, as long as the account has been open for the five-year holding period. In addition, Roth IRAs do not have the required minimum distribution at age 70 ½ as do the traditional IRAs.

Other Considerations

Depending on the amount of the traditional IRA that you would like to convert and your tax bracket, it could be beneficial to convert a portion in 2011 and a portion in 2012.

While you must convert by year end to qualify for a conversion in that taxable year, there is a re-characterization rule that allows you to undo the conversion up until the extended due date of the return of the conversion year.  This is incredibly important as it allows taxpayers the benefit of hindsight. For example, assume a taxpayer converted her traditional IRA to a Roth at the end of 2011.  At the time of conversion, the IRA was worth $100,000.  On October 10, 2012, the Roth IRA is worth $135,000.  The taxpayer has effectively sheltered $35,000 of income from future income tax and no reason to re-characterize!  However, assume the Roth IRA is worth $75,000 on October 10, 2012.  In this situation, it would be wise to re-characterize the 2011 conversion back to a traditional IRA since the account has declined in value and there is no reason to pay tax on $25,000 of income that no longer exists.

Now that the $100,000 MAGI limit has been repealed, it makes sense for taxpayers above this limit, to evaluate their current situation and consider conversion. Wilson, LLP would be happy to help you estimate the tax due on a conversion and evaluate the decision of making a conversion.