The U.S. government removed the restrictions on converting traditional IRA contributions to Roth accounts in 2010, saying that taxpayers with any level of modified adjusted gross income could take advantage of the tax-free gains in a Roth IRA by moving money from existing traditional IRA accounts. When performing a rollover, you will need to claim the amount you convert, depending on the type of contribution you made to your traditional IRA, as income, and pay any applicable taxes on that amount.
Deductible Traditional IRA Contributions
You will pay taxes on traditional IRA contributions rolled into a Roth IRA account that you claimed a deduction for on your tax returns. Most people who qualify claim a tax deduction for traditional IRA contributions.
Non-Deductible Traditional IRA Contributions
You may have made nondeductible contributions to your IRA account if you didn't qualify for deductible contributions. Because you have already paid the taxes on these contributions, you will not owe additional taxes when converting this money to a Roth IRA.
IRA Investment Gains
Investment gains in a traditional IRA account will always be taxable when converted to a Roth, regardless of the type of contribution made. This is because under no circumstances have you paid taxes on these investment gains previously.
A 401(k) plan can be rolled over into a Roth IRA if the plan is with an employer that you no longer work for. Most 401(k) plans are funded with before-tax contributions, and you will need to pay the taxes on these contributions when converted to a Roth IRA. Company matches and other contributions, as well as investment gains are on a pre-tax basis, and would be taxable when converted.
Taxable as Income
Taxable IRA conversions to a Roth IRA are taxable as income in the year of the conversion, except for some conversions made in 2010. Taxes are assessed at your normal income tax rate. For example, if you completed taxable Roth conversions of $20,000, and you are in the 25-percent tax bracket, you would owe $5,000 in taxes on your conversion.
Benefits of Conversion
Even when considering the taxes, you can enjoy significant benefits to roll over your traditional IRA. All of your Roth IRA contributions grow tax-free. In addition, you can withdraw Roth contributions and converted amounts without taxes or penalties at any time. Also, Roth IRA accounts do not require minimum withdrawals at any time, allowing your money to continue compounding tax-free.
Pay Taxes Outside of IRA
It's best to pay for the taxes on your IRA conversion with money available outside of your IRA account. If you withdraw $5,000 from your IRA to pay taxes on the conversion, you will also owe a 10 percent penalty for the amount you withdraw in addition to the taxes on that amount if you are younger than 59 1/2.
If you roll over your traditional IRA to a Roth IRA, you can decide to reverse the rollover decision by October 15 of the following year, with no tax ramifications. This is helpful if your converted Roth IRA loses significant value after conversion, so you don't need to pay taxes on value that is no longer there.