Tradeoffs
You have to pay tax now on the funds that you convert or roll over
When you convert or roll over funds from a traditional IRA to a Roth IRA, the funds that you transfer are subject to federal income tax (to the extent that those funds represent investment earnings and tax-deductible contributions made to the traditional IRA). Even if it makes overall financial sense to convert funds from a traditional IRA to a Roth IRA, paying tax on your IRA funds now may not be desirable.
Tip: Special rules apply to conversions made in 2010. The amount that must be included in income as a result of the conversion will be able to be averaged over the next two years. That is, the resulting income can be reported on the individual's 2010 tax return. Or, instead, half of the income may be reported on the individual's 2011 tax return, and the remaining half on the 2012 tax return.
Using IRA funds to pay conversion tax has significant drawbacks
If using other IRA dollars is the only way that you can pay the conversion tax that results from converting or rolling over funds from a traditional IRA to a Roth IRA, the benefits of converting or rolling over funds are substantially reduced. Using IRA dollars to pay the tax reduces the amount of funds in your IRAs, potentially jeopardizing your retirement goals. In addition, the IRA funds used to pay the tax may themselves be subject to federal income tax and a premature distribution tax. If possible, paying the conversion tax with non-IRA funds is generally more advisable.
Special penalty provisions may apply to withdrawals from Roth IRAs that contain funds converted from traditional IRAs
If you're under age 59˝ and take a non qualified distribution from a Roth IRA, the 10 percent premature distribution tax generally applies only to that portion of the distribution that represents investment earnings. However, if you convert or roll over funds from a traditional IRA to a Roth IRA and then take a premature distribution from that Roth IRA within five years, the 10 percent premature distribution tax will apply to the entire amount of the distribution (to the extent that the distribution consists of funds that were taxed at the time of conversion).
Tip: The five-year holding period begins on January 1 of the tax year in which you converted or rolled over the funds from the traditional IRA to the Roth IRA. When applying this special rule, a separate five-year holding period applies each time you convert or roll over funds from a traditional IRA to a Roth IRA.
Taxable income resulting from conversion can increase taxable portion of Social Security benefits being received
If you're currently receiving Social Security benefits or soon will be, consider the possible tax consequences of converting or rolling over funds from a traditional IRA to a Roth IRA. When you convert or roll over funds, those funds are generally considered taxable income to you for the year in which you transfer them. Remember that the portion of your Social Security benefits that is taxable (if any) depends on your income and tax filing status for the year. This means that converting funds to a Roth IRA may increase the taxable portion of your Social Security benefits for that year.
Risk of future change in the law
One of the main reasons to consider converting or rolling over funds from a traditional IRA to a Roth IRA is that qualified distributions from Roth IRAs are completely tax free. Under current law, this is the federal tax treatment given to Roth IRAs. Some experts, however, are skeptical that this will always remain the case, given the uncertain status of Social Security and the projected lost federal revenue attributable to Roth IRAs.
States may differ in their treatment of Roth IRAs
Although most states follow the federal tax treatment of Roth IRAs, you should check with a tax professional regarding the tax treatment of Roth IRAs in your particular state.
Creditor protection
Federal law provides protection for up to $1,095,000 (as of 4/1/07) of your aggregate Roth and traditional IRA assets if you declare bankruptcy. (Amounts rolled over to the IRA from an employer qualified plan or 403(b) plan, plus any earnings on the rollover, aren't subject to this dollar cap and are fully protected.) The laws of your particular state may provide additional bankruptcy protection, and may provide protection from the claims of your creditors in cases outside of bankruptcy. In some states the creditor protection available to Roth IRAs may be less than that available to traditional IRAs.
