What are the Challenges of Converting an IRA?

Converting a traditional IRA to a Roth IRA gives you the opportunity to benefit from a versatile account with the potential for tax free distributions. However, the conversion process can be costly if you don't avoid certain pitfalls. Before converting a traditional IRA to a Roth, get IRA management help and talk with your custodian or trustee about the specifics of your Individual Retirement account and how the funds will be converted. Some financial institutions will transfer the funds directly between financial institutions or accounts, while others will distribute the funds directly to you.

Tax Requirements

Meeting the tax requirements of conversion is one of the biggest challenges of converting an IRA. Converting assets from a traditional to a Roth IRA involves a change in tax status for these funds. The contributions you make to a traditional IRA come from pre-tax income, while the contributions that you make to a Roth IRA come from aftertax income. Because the funds in a traditional IRA have not been taxed, these assets will be subject to income tax when you convert the assets to a Roth IRA.

You must include the funds that you convert from a traditional to a Roth IRA in your income for that tax year. If you need a tax break in the current tax year, it may be best to wait to convert your traditional IRA. Otherwise, you may end up paying more income tax as a result of the conversion. Talk with your investment advisor or a tax professional about the tax requirements of an IRA conversion in order to avoid an excessive tax burden.

An increase in income for a particular year may be a problem for families with college-age students who are applying for financial aid. If household income exceeds a certain limit, a student may not qualify for certain types of aid. Parents whose children are in the process of applying for federal grants or scholarships should consider holding off on a conversion until their child's request for aid has been approved.

When withdrawing funds from a converted IRA, it's important to review the eligibility requirements to avoid a 10 percent tax penalty on the distributions. After converting a traditional IRA to a Roth, you may have more flexibility in the timing of your distributions. However, certain restrictions apply that may trigger a tax penalty. Account holders under the age of 59 1/2 may be charged a 10 percent penalty on distributions from converted assets if the Roth IRA is less than 5 years old.

Time Limitations

The IRS imposes a time limitation on converting assets from a traditional IRA to a Roth IRA. If you take a distribution from your traditional IRA in order to convert these funds to a Roth, you must complete the conversion within 60 days. Otherwise, the distribution must be included in your income tax for that year, and the funds will no longer be eligible for conversion. If possible, the safest option is to arrange a conversion directly from one trustee to another, but these direct transfers are not always possible.

In spite of the challenges of converting an IRA to a Roth IRA, many taxpayers choose this strategy in order to reap the tax benefits of a Roth. The contributions you make to a Roth IRA can continue to grow tax free until you are ready to take distributions. Unlike a traditional IRA, a Roth does not impose minimum distribution requirements, so you can continue to allow your assets to grow past the age of 70. Consult a tax advisor about the potential costs of a conversion before you make this decision.

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