Tax Benefits and Allocation Issues in Rollovers to Roth IRAs

A Roth individual retirement account offers valuable tax benefits, because it allows your investments to grow tax-free. Furthermore, although the money you contribute to a Roth IRA is not deductible, if you avoid early withdrawals, you can take money out of your Roth IRA without increasing your taxable income. If you roll a traditional IRA or other qualified retirement plan into a Roth IRA, you’ll have to pay taxes, except on the portion representing nondeductible contributions.

Cost Basis

The cost basis of a qualified retirement account is the money you contributed but did not deduct from income taxes. This can occur in a traditional IRA if you or your spouse belonged to a workplace retirement plan when you contributed to the IRA. If you are enrolled at work, are single and your modified adjusted gross income in 2013 is between $59,001 and $68,999, you can take a partial deduction. MAGI above the top of the range means you get no deduction. The partial deduction range for married couples filing jointly is $95,001 and $114,999. If you didn’t participate in a workplace plan but your spouse did, the partial deduction range is $178,001 and $187,999.

Roth Conversion

If your current account has no cost basis, you pay tax on the full amount you roll over into a Roth IRA. If your traditional account has a cost basis, exclude it from the taxable income you create through a conversion. It’s straightforward for full conversions, but you’ll need a little math for a partial conversion of an account with a cost basis. You must prorate the cost basis for the amount you convert. For example, suppose your traditional IRA has a value of $100,000 of which $5,000 represents nondeductible contributions. If you convert $50,000 to a Roth IRA, allocate $2,500 to cost basis and $47,500 to taxable income.

Additional Tax

The Internal Revenue Service normally charges a 10 percent additional tax if you withdraw money from an IRA before age 59 1/2. You avoid this penalty when you perform a Roth conversion, as long as you observe the rules. If you first withdraw from your traditional account, you have 60 days to deposit the proceeds into the Roth account, or else the IRS will charge the additional tax on early withdrawals. You can avoid this deadline by requesting a trustee-to-trustee transfer, which the IRS does not consider a distribution. To arrange the transfer, fill out forms with the old and new trustee detailing the property you want to transfer.

Considerations

If you roll over a qualified account with a cost basis to a Roth IRA, fill out Worksheet 1-5 in IRS Publication 590 and Form 8606. Your custodian will send you Form 1099-R reporting the distribution from the old account. Verify the form’s distribution code correctly to indicate that the proceeds were moved into a Roth IRA. If you mark the form incorrectly, have your custodian issue a revised Form 1099-R. The money in your Roth IRA can remain there as long as you live -- this type of account has no required minimum distributions. Normally, your beneficiary will have to dispose of the Roth IRA within five years, though a surviving spouse can combine it with his or her own Roth. If you roll over, rather than transfer, a workplace retirement plan, your custodian will withhold 20 percent of the amount. If you don’t replenish the 20 percent when you contribute to the Roth IRA and you’re younger than 59 1/2, the IRS will extract a 10 percent additional tax on the 20 percent.