How to Convert a Traditional IRA to ROTH IRA?

I’m currently trying to figure out how to convert my traditional IRA to a ROTH IRA. The only reason I contributed to a traditional IRA for the last two years was because I thought each year my income would exceed the income limits for a ROTH IRA.

Well, it turns out the income limits for a traditional IRA are lower than those for a ROTH contribution. Thus, I’ve invested $10,000 into a traditional IRA for the last two years and put post-tax money into the account, and will be paying tax when I retire later in life and take the money out of the account. I think that’s probably a bad idea, so I want to convert the $10k to a Roth.

The question I have is… how do I do that? Sharebuilder has a form for this, but it seems to assume you put the funds in pre-tax. I’ve heard if you paid tax of money in the account already, then you only will have to pay tax on the interest in a conversion. Given I still have 30+ years before retirement, it probably makes sense to convert the funds now, especially if I only have to pay tax on the $1k.

Do any of you out there in cyberland know how I can do this without paying tax on the entire $11k in this account?

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5 comments

  1. Joy ( User Karma: 0 ) says:

    Thanks for the advice Don. This is very helpful. I plan to do that, as well as to convert the IRA to a Roth. There is only $866 of interest right now so I won't have to pay that much in tax to convert it.

  2. don says:

    If you have not filed IRS form 8606 for all the years you contributed post tax IRA contributions, you can do it now and send it in, even after the fact. The form 8606 is a paper trail for your basis in the IRA. Best to do a Roth, as 30 years from now you may forget about the post-tax money. Best to simplify…. I don't live in CA, but it sounds like the 10% will be for withholding CA taxes and any excess will be returned. The way the taxes are now it is best to avoid having a traditional IRA (where deductions/credits were not taken off 1040) by converting immediately to a Roth or just keeping $ in a taxable account if you are investing in securities. Money in a traditional IRA that is invested in securities is taxed at an earned income rate, while in a taxable account is taxed at capital gains and qualified dividend rates. That may change though.

  3. don says:

    Did you deduct or take a credit for your IRA contributions on your 1040 IRS form? Did you file IRS form 8606 Nondeductable IRAs? If you made contributions of 10K (and did not deduct/credit from taxes on 1040) in an account worth 15K, taxes will only be on 5K. If you took the deductions or credit each year on your 1040, then your basis will be the entire amount or 15K.
    When you retire your post-tax contributions will not be taxed again (if the deduction/credit was not taken), but withdrawals will be prorated for taxes. For example if 10K out of 100K was post tax, then you will pay taxes on 90% of each withdrawal.
    You should convert the traditional IRA to a Roth ASAP, as you are young and a Roth will ensure many years of untaxed growth. So if you made contributions of 10K (and did not deduct/credit from taxes on 1040) in an account worth 15K, taxes will only be on 5K when converting to a Roth. Your financial institution can do the conversion, but you need to make estimated income tax payments to the IRS. Some states do not tax Roth conversions.

    1. Joy ( User Karma: 0 ) says:

      Thanks Don. I did not report my IRA contribution to the IRS, nor did I file 8606 (I did not know this existed! Thanks for letting me know.) The conversion makes a lot of sense, given some losses my account is only worth $11k right now, and I'd pay tax on just $1k interest.

      I found a form on Sharebuilder to do a conversion but it says California requires you to withhold 10% in a conversion of your Roth account, which is going to be more than I owe for taxes. I guess that's ok as I might be able to get that back in April?

  4. Leigh says:

    I would try calling Sharebuilder. I don't know how to do it with them, but with Vanguard I was able to recharacterize my contributions. The guy on the phone directed me at the correct forms to use.

    So for your 2011 contribution, you can recharacterize (http://www.bogleheads.org/wiki/IRA_recharacterization) it, but for your 2010 contribution you have to convert (http://www.bogleheads.org/wiki/Roth_IRA_conversion) it.

    I had a longer comment up, but it seems to have disappeared.

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