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Tutorial: Roth IRA Conversions

A Roth IRA conversion is a movement of assets from any of the following accounts to a Roth IRA.
For the purpose of this tutorial, these accounts are referred to as the ‘delivering accounts’.
Roth Conversion Eligibility Requirements
An individual can completed a Roth IRA conversion whether or not she has income/compensation for the year.
For Roth conversions that are done before January 1, 2010, the Roth IRA owner must meet the following requirements:
These limitations are repealed effective January 1, 2010.
No other limitations or eligibility requirements apply to a Roth IRA conversion.
How to Complete a Roth IRA Conversion
A Roth IRA conversion should be completed in accordance with the operational and compliance requirements of the financial institutions (and -if applicable- plan administrator) that are involved in the conversion.  In general, a Roth IRA conversion is accomplished as follows:
  1. The assets are distributed from the delivering account and credited to the Roth IRA. This can occur between accounts held at the same financial institution, or between accounts held at different financial institutions, or
  2. In the case of a traditional IRA, SEP IRA or SIMPLE IRA that has met the two-year requirement, the account is redesignated as a Roth IRA[2]. In this case, the documentation and operational requirements for opening a new Roth IRA would apply.
The financial institutions involved in the Roth conversion will have documentation and operational requirements that must be satisfied in order for the Roth conversion to be completed.
Indirect Vs Direct Conversions
A Roth IRA Conversion can be accomplished as a direct conversion or as an indirect conversion.
  • With an indirect conversion, the funds/assets are paid to the account owner and deposited to the Roth IRA within 60-days of receipt. For tax reporting purposes, the delivery of the assets are treated as a regular distribution. As such, if the delivery is made from a qualified plan, 403(b) account, 403(a) annuity, or a governmental 457(b) account, the payer is required to withhold 20% of the taxable amount for federal taxes.
  • With a direct conversion, the funds/assets are paid by the trustee/custodian/plan administrator of the delivering account to the Roth IRA trustee/custodian, and treated for operational and tax-reporting purposes as a direct Roth conversion or a direct rollover contribution. There is no time limit on when the funds must be credited to the Roth IRA.
Whichever method is used, the Roth IRA owner should consult with the parties responsible for delivering and receiving the assets, to ensure that the documentation and operational requirements are satisfied on both sides.
Partial Conversions Permissible
An individual need not convert the entire balance from her delivering account to her Roth IRA. Instead, she can convert a portion of the balance. Partial conversions are often done, instead of full conversions for reasons which include the following:
  • The individual cannot afford to pay the tax that would be due on the full conversion
  • The individual wants to spread the income from the conversion over several years, and would therefore convert a portion each of that year.
  • The individual does not want to move all of the assets into a Roth IRA
If a full conversion was completed and the Roth IRA owner determines that a partial conversion would have been a better option, this can be ‘corrected’ by recharacterizing a portion of the Roth conversion. For an explanation of the recharacterization rules, see Tutorial: Roth IRA Recharacterizations.
Amounts that Cannot Be Converted to a Roth IRA
An amount can be converted to a Roth IRA, only if the amount is rollover eligible. As such, the following amounts cannot be converted to a Roth IRA.
  • Required minimum distribution  amounts. If the individual is required to take an RMD from the account for the year, the RMD must be withdrawn before the conversion is completed. If the conversion will be completed as an indirect conversion, the RMD can be included in the amount withdrawn, but the individual must ensure that the amount credited to the Roth IRA does not include the RMD amount.
Example: Johnis 75 years old and retired. He plans to convert his 401(k) account balance of $100,000 to his Roth IRA this year. His RMD amount for the year is $4,367. He wants to request a distribution of the entire balance of his 401(k), and instruct the plan administrator to send the amount directly to his Roth IRA custodian, with instructions to deposit the amount to his Roth IRA. John must withdraw the $4,367 before the conversion to the Roth IRA is completed. If he fails to withdraw the RMD amount before the conversion, the $4,367 will create an excess ineligible rollover contribution to his Roth IRA.
  • Any of a series of substantially equal distributions paid at least once a year over:
        1. The participant’s  lifetime or life expectancy,
        2. The joint lives or life expectancies of the participant and his/her beneficiary, or
        3. A period of 10 years or more,
  • Hardship distributions,
  • Corrective distributions of excess contributions or excess deferrals, and any income allocable to the excess, or of excess annual additions and any allocable gains 
  • A loan treated as a distribution because it does not satisfy certain requirements either when made or later (such as upon default), unless the participant's accrued benefits are reduced (offset) to repay the loan
  • Dividends on employer securities, and
  • The cost of life insurance coverage.
Tax Treatment of Roth Conversions
A Roth conversion is includible in the Roth IRA owner’s gross income. As such, except for amounts representing after-tax contributions or nondeductible contributions to an IRA, the conversion amount will be taxable.
The 10% early distribution penalty does not apply to a Roth conversion, regardless of the individual’s age at the time the conversion occurs.
Roth conversions are required to be included in the Roth IRA owner's income for the year the conversion occurs. An exception applies to conversions that are done in 2010. Under this exception, the income from the conversion can be spread over 2011 and 2012 in equal amounts. For instance, if $100,000 was converted in 2010, $50,000 would be added to the Roth IRA owner's income for 2011 and the balance of $50,000 added to his income for 2012.
Tax Withholding On Conversions
If the conversion is done from a qualified plan, 403(b) plan, 403(a) qualified annuity plan, or governmental 457(b) account, it is not subject to the 20% mandatory withholding that usually applies to taxable amounts that are paid to the account owner. Instead, the plan administrator would withhold zero tax, unless the account owner requests to have taxes withheld.[3]
If the conversion is done from a traditional IRA, SEP IRA or SIMPLE IRA, the IRA custodian/trustee is required to withhold 10 % for federal tax, unless the IRA owner request to have no tax withheld.
Withheld Amount is Not A Conversion
Any amount withheld as tax from a Roth IRA conversion is treated as a regular distribution.
John request to have the 401(k) balance of $100,000 converted to his Roth IRA. He instructed the plan administrator to withhold 20% for federal tax. As a result only $80,000 was credited to the Roth IRA and 20% was remitted to the IRS as a pre-payment of tax for John.
The $20,000 that was withheld for tax is treated as a regular distribution and is subject to income tax and the 10% early distribution penalty on any taxable amount. The 10% early distribution penalty does not apply, if the conversion occurred when John was at least age 59 ½ of if john qualifies for one of the exception to the penalty.
Deadline for Completing Roth IRA Conversions
A Roth IRA conversion must be completed by December 31 of a year, in order for it to be treated as a Roth IRA conversion for that year. For this purpose, the effective date of the conversion is the date the assets leave the delivering account. As such, if an individual takes a distribution from a delivering account on December 15, 2009 and the amount is credited to the Roth IRA on January 20, 2010, the transaction is considered to be a 2009-conversion.

[1] IRC § 408A(d)(3)
[2] Treas. Reg. 1.408A-2 Q&A 2
[3] IRS Notice 2008-30- Q&A-6
                    I.            Tutorial: Roth IRA Contributions
                  II.            Tutorial: Excess Roth IRA Contributions
                III.            Tutorial: Roth IRA Conversions
               IV.            Tutorial: Roth IRA Reconversions
                 V.            Tutorial: Roth IRA Rollovers and Transfers