You include funds that are converted or rolled over from a traditional IRA to a Roth IRA in income
When you convert or roll over funds from a traditional IRA to a Roth IRA, those funds are subject to federal income tax in the year that you transfer them (to the extent that the funds consist of deductible contributions and investment earnings). If you have made only deductible contributions to your traditional IRAs, then the entire amount of any funds that you convert or roll over to a Roth IRA will be taxable. If, however, you have ever made nondeductible (after-tax) contributions to your traditional IRAs, then those contribution amounts will not be taxable when converted or rolled over to a Roth IRA (since they have already been taxed). In effect, the income tax consequences of converting funds are the same as those that apply when you make a withdrawal from a traditional IRA.
Tip: Amounts that must be included in your taxable income as a result of converting funds from a traditional IRA to a Roth IRA are not considered when determining if you qualify to convert funds in the first place.
Application of the 10 percent premature distribution tax
The 10 percent premature distribution tax does not apply at the time that you convert or roll over funds from a traditional IRA to a Roth IRA, even if you convert the funds before reaching age 59˝. However, if you convert or roll over funds from a traditional IRA to a Roth IRA and withdraw any portion of those funds from the Roth IRA within five years (and prior to age 59˝), the withdrawal will be subject to the 10 percent premature distribution tax (to the extent those funds were taxed at the time of the conversion).
Caution: Remember that withdrawals from Roth IRAs are treated as coming from contributions first and investment earnings second. Contributions are considered to consist first of regular contributions (i.e., contributions other than rollover contributions), and then of amounts converted or rolled over from a traditional IRA (on a first in, first out basis).
Tip: All of your Roth IRAs are aggregated for this purpose.
Example(s): John is age 40. John contributed $3,000 to his Roth IRA in 2007. In 2008, John converted $10,000 from his traditional IRA to his Roth IRA, and included this $10,000 in his 2008 gross income. He made no further contributions to his Roth IRA. In 2010, his Roth IRA has grown to $14,000, of which John withdraws $4,000. None of the exceptions to the 10 percent premature distribution tax apply to John. John's $4,000 withdrawal is considered to consist first of his $3,000 regular contribution made in 2007. John owes no premature distribution tax on this $3,000. The remaining $1,000 of John's $4,000 withdrawal is considered to consist of funds he converted from his traditional IRA, and is subject to the 10 percent premature distribution tax.
You can't convert or roll over RMDs into a Roth IRA
After age 70˝, you are required to begin taking annual minimum withdrawals from your traditional IRAs (RMDs). You cannot roll over or convert these RMD amounts to a Roth IRA.
Special rules apply to conversions made in 2010
For Roth conversions made in 2010 only, the amount includible in gross income as a result of the conversion will be averaged over the following two years, unless the taxpayer elects otherwise. That is, no resulting income will be reported on the individual's 2010 federal income tax return. Half the resulting income will be reported on the taxpayer's tax return for 2011, and the remaining half will be reported on the taxpayer's tax return for 2012.
Caution: Income inclusion will be accelerated if converted amounts are distributed before 2012. In that case, the amount included in income in the year of distribution is increased by the amount distributed, and the amount included in income in 2012 (or 2011 if the distribution takes place in 2010) is the lesser of: (1) half of the amount includible in income as a result of the conversion, and (2) the remaining portion of such amount not already included in income.
Example(s): [From Joint Explanatory Statement of the Committee of Conference] Taxpayer A has a traditional IRA with a value of $100, consisting of deductible contributions and earnings. A does not have a Roth IRA. A converts the traditional IRA to a Roth IRA in 2010, and, as a result of the conversion, $100 is includible in gross income. Unless A elects otherwise, $50 of the income resulting from the conversion is included in income in 2011, and $50 in 2012. Later in 2010, A takes a $20 distribution, which is not a qualified distribution and all of which, under the ordering rules, is attributable to amounts includible in gross income as a result of the conversion. Under the accelerated inclusion rule, $20 is included in income in 2010. The amount included in income in 2011 is the lesser of: (1) $50 (half of the income resulting from the conversion), or (2) $70 (the remaining income from the conversion), in other words -- $50. The amount included in income in 2012 is the lesser of: (1) $50 (half of the income resulting from the conversion), or (2) the remaining income from the conversion, i.e., $100 - $70 ($20 included in income in 2010 and $50 included in income in 2011), in other words -- $30.
