Roth IRA is confusing even to financial advisers
This is why I must keep writing about Roth IRA conversions:
A dozen readers age 70 1/2 and older have written to say their financial advisers recommended they convert their entire traditional IRAs to Roth IRAs this year. By converting everything, the advisers claimed, they’d avoid having to take required minimum distributions from their traditional IRAs for 2010.
That’s incorrect and potentially very costly advice.
"It’s absolutely not true," said Ed Slott, a certified public accountant in Rockville Centre, N.Y., who publishes a monthly "IRA Advisor" newsletter for financial professionals (at www.irahelp.com). After age 70-1/2, holders of traditional IRAs must start withdrawing a minimum amount each year (the required minimum distribution or "RMD"). This distribution must be taken before any remaining funds can be converted to a Roth IRA.
Failure to take a required distribution is subject to a 50 percent penalty on the amount that should have been withdrawn but wasn’t. Any RMD funds mistakenly "converted" into a Roth IRA can be considered an "excess" contribution to the Roth IRA, resulting in a 6 percent excise penalty for every year the money remains in the Roth IRA, Slott said.
To answer a common question, people eligible to make a direct contribution to a Roth IRA — which is different from a conversion — can certainly use money from an RMD for the contribution. But to be eligible to contribute, you or your spouse must have "earned income," which means mostly income from work — the RMD itself does not qualify — and your income cannot exceed certain limits. The IRA direct contribution limit for 2010 is $6,000 for people 50 and over, while conversions have no limit.
Slott, who runs training seminars for financial professionals on IRAs, said he’s found a general lack of knowledge about the rules and potential pitfalls of Roth IRA conversions among many advisers no fax pay day loans.
"I am starting to realize how much they don’t know," Slott said, particularly bank employees and brokers who are not tax-law specialists. As of this year, anybody with a traditional IRA is eligible to convert to a Roth. Whether it makes sense to do so depends on a host of individual circumstances, which is why getting good advice is important.
But bad advice abounds. Another reader said he decided against converting because his adviser told him that, once in the Roth IRA, the converted funds could not be withdrawn for five years.
"That’s wrong, too," Slott said. Converted funds can be withdrawn at any time, although there may be penalties.
But penalties are probably not as bad as you think. A much-feared 10 percent tax penalty on withdrawals applies only if you withdraw the converted funds before age 591/2 and also have not held the funds for at least five years.
Once you are at least 591/2, "there is no more 10 percent penalty, period," even if you withdraw the money right after you convert, Slott emphasized. Five years after a conversion, and once you are at least 591/2, all the money, including any subsequent investment gains, can be withdrawn tax-free.
Even if you are 591/2 or older, if you withdraw converted funds within five years, you would owe ordinary income taxes on any investment gains since the conversion — but not on the amount converted. Taxes can be minimized or avoided through well-timed partial withdrawals. The first funds withdrawn from a Roth IRA are generally considered to be any direct contributions and converted principal, which have already been taxed and would not be taxed again.