New Rules for Converting to a Roth IRA
The New Year removes a key restriction for many individuals—the ability to convert pretax funds to a Roth IRA. Prior to January 1, 2010, only taxpayers who met certain income requirements were allowed to convert funds in a tax-deferred account (e.g., traditional IRA, 401(k), 403(b), 457, SEP-IRA) into a Roth IRA. Now this restriction has been removed. Since you will still have to report the converted funds as income and pay the associated taxes, you need to consider whether converting funds to a Roth IRA is beneficial for your particular financial situation.
Tax-Deferred Accounts Versus
Tax-Exempt Roth Accounts
Tax-deferred accounts such as traditional IRAs and 401(k)s generally contain pretax dollars. Funds in tax-deferred accounts grow tax deferred until distribution. Withdrawals are taxed as ordinary income. Withdrawals (but not conversions) made before age 59½ are generally subject to an additional 10% penalty tax. Relatively few taxpayers have made non-deductible (aftertax) contributions to a traditional IRA or other tax-deferred accounts, in which case they would have a mix of pretax and aftertax funds in these accounts. We discuss these exceptions later. For now, we assume tax-deferred accounts contain only pretax dollars.
In contrast, Roth IRAs, Roth 401(k)s, and Roth 403(b)s contain aftertax dollars. Withdrawals from these tax-exempt accounts are tax free as long as the individual is at least 59½ and the funds have been in the Roth account for at least five years.
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Alicia Waltenberger is an estate and tax planning attorney and wealth planning specialist at TIAA-CREF. firstname.lastname@example.org.
Douglas Rothermich is an estate and tax planning attorney and vice president, wealth planning strategies, at TIAA-CREF. email@example.com.