For Shift to Roth I.R.A., Know the Pitfalls to Avoid
By DEBORAH L. JACOBS
CONVERTING a traditional individual retirement account to a Roth I.R.A. is a widely discussed financial planning tool right now, but the mechanics can be tricky. The process is new to many people, because until this year, you were shut out of a Roth if your adjusted gross income was more than $100,000.
Those who make the shift must pay income tax on the amount converted, which can be the whole account or just part of it. Still, the benefits are enticing: with a Roth, you are not required to take yearly minimum distributions starting at age 70 1/2, and future withdrawals are not taxed, whether you use the money yourself or leave it to beneficiaries. Knowing the pitfalls to look for can help you steer around them.
TAKE A DISTRIBUTION FIRST If you are required to take distributions because of your age, take the payout for 2010 before converting the entire I.R.A. to a Roth, said Natalie B. Choate, a Boston lawyer and author of “Life and Death Planning for Retirement Benefits” (2006, Ataxplan Publications). Unless you do, the money is considered an excess Roth contribution, and you must withdraw it by the next April 15 or face a 6 percent penalty.
CHOOSE THE BEST PATH Most people open a Roth at the same financial institution where they already have a traditional I.R.A. In that case, they can simply transfer investments from one account to the other. But to move money between institutions, you may need to cash out investments, said Michael J. Jones, a lawyer and certified public accountant with Thompson Jones in Monterey, Calif. One possibility is to withdraw the funds and redeposit them, but you must do this within 60 days or it is considered a taxable withdrawal.
If you open a Roth at the company receiving the funds and ask it to retrieve the money, he said, there is less room for foul-ups. At many institutions, you can open the necessary accounts and make the conversions online, over the phone or by filling out a form.
OPT OUT OF WITHHOLDING Financial institutions are required to withhold at least 10 percent for federal income taxes unless you ask them not to. On their Roth conversion forms, you indicate your preference by checking (or, in some cases, not checking) a box.
Read the instructions carefully and specify that you do not want taxes withheld, said Barry C. Picker, an accountant and financial planner with Picker & Auerbach in Brooklyn. Otherwise, the money withheld is subject to tax and, of course, goes to the government rather than into your Roth account. People under 59 1/2 are hit with a 10 percent penalty in addition because the amount withheld is considered an early withdrawal.
That’s what happened to Kathleen Wasescha Clifford, 56, of Edina, Minn., who worked as an institutional investor for 18 years before retiring. She failed to check the appropriate box when she converted her $450,000 I.R.A. to a Roth in September 2008. As a result, $45,000 was automatically withheld for taxes, reducing the sum in the Roth account to $405,000.
You have the right to undo a conversion through Oct. 15 of the next year, and after the market swooned, Ms. Clifford did, turning the account back into a traditional I.R.A. last spring. So she no longer owed taxes on the $405,000, but she could not get back the tax she had to pay on that $45,000 or the 10 percent penalty for early withdrawal. Ms. Clifford figures this cost her a total of $20,000. The remaining $25,000 now sits in a nonretirement account.
If you make this mistake but catch it within 60 days of when the money was taken out, said Ms. Choate, you can substitute money from another source for what was withheld. For example, Ms. Clifford could have taken $45,000 out of a nonretirement account and deposited it in the Roth. However, by the time she discovered her mistake, it was too late.
SELECT BENEFICIARIES Money in an I.R.A. cannot be distributed by a will. Rather, it goes to the people you name on the beneficiary designation form you fill out for each account. When setting up a Roth, you need to complete a new form, said Christopher R. Hoyt, a professor at the University of Missouri-Kansas City School of Law. You cannot use the beneficiary form from the traditional I.R.A.
TRACK THE MONEY Confirm that the balance in the traditional I.R.A. has been reduced by the amount you converted, and that a corresponding amount appears in a separate account that is clearly labeled a Roth. Most errors (like accidental deposits into a checking account) can be fixed if you catch them within 60 days, said Ed Slott, a certified public accountant and I.R.A. specialist in Rockville Centre, N.Y.