10 Things to Consider Before Converting To Roth IRA

Right now, many people are using special time to convert their 401K or Traditional IRA in to ROTH IRA. Many financial advisers and personal finance experts are saying why this is the best time to do it, and even though 2010 is over, there is still good time for anyone to take an advantage of the time to convert your retirement money such as 401K, 403b and traditional IRA in to Roth IRA.

Many calls to Mutual fund advisers and comments based on many forums I see there are some confusion about it. Roth IRA is not for everyone, how to know if you are doing it right and if it is right for you? There are 10 things to consider before you make changes to your retirement plan. If you already have converted your 401K or IRA in to Roth IRA, fret not, simple steps to you financial adviser can sort out any issues, hopefully.

To find out if Roth IRA conversion is right for you, please check out these 10 things for any possible traps or issue regarding the conversion. It is not fun to do something and find out your retirement fund is screwed up.

1. On a 2010 conversion the income is split, Tax is not split.

One of the main benefit of doing conversion for people is, that their income from converting to Roth can be split in to 2010 and 2011. For example, if you had $20,000 in your 401K, you can convert 20K in Roth now but choose to make 10K as an income in 2010 and 10K for income for 2011, making your earned income realistic. The bad part is, you will still have to pay Taxes on $20K on 2010. Many people are not aware of that and it comes as a shock to them.

2. You have only 60 days to roll over:

The best way to move money from an IRA to a Roth IRA is by trustee-to-trustee transfer -- a direct rollover of the whole retirement fund. However, some of the custodians or finance companies are not doing this type of transfer, and they are offering you a check, which in turn you have to deposit and start and finish the process of Roth IRA within 60 days.

If you do not get to finish it in 60 days, you will have to pay taxes and 10 % penalty on the fund. What is worse is that after 60 days, you will not be eligible for Roth IRA conversion based on Market watch financial expert. So, make sure you are prepared when you start the process of the conversion.

3. Loss of Financial aid

Most schools and colleges exclude a parent's retirement assets when considering a college student's eligibility for financial aid. However, when you have Roth IRA, which is not considered traditional retirement income and may cause a loss of financial aid for you, or your child. So, keep that in mind when you think of Roth IRA is right for you or not.

5. Partial conversions involving after-tax money

When you have after-tax money in an IRA, you can't isolate the after-tax amounts and convert them tax-free while keeping the remaining pre-tax dollars in the traditional IRA. It is complex calculations taking sugar out after mixing it in your coffee. So, if you want to do partial Roth IRA conversion, a pro-rated amount of after-tax money, or basis, is included with each dollar converted. The formula for calculating this amount is this: Total basis in all IRAs divided by the total value of all IRAs times the amount converted. You will know once you start the process what number its comes out, I sure do not like not knowing numbers before hand.

6. Not all funds are not eligible for conversion or contribution

You might think you can convert anything into a Roth IRA, but you'd be wrong.You can only do eligible rollover distribution in to Roth IRA according to conversion guideline. Things that are not eligible are, Requireed Minimum Distribution (RMDs), there are a number of other items that can't be converted, including 72(t) payments, hardship distributions, corrective distributions of excess deferrals, deemed distributions, and dividends from employer securities.

7. The SIMPLE IRA 25% penalty

All IRAs, including SEP IRAs and SIMPLE IRAs, are eligible for conversion to a Roth IRA. Other types of IRA can be converted anytime without penalty, however, if you have SIMPLE IRA, things are not so rosy. SIMPLE IRA has 2 year holding period and if you leave funds within these 2 years based on when you made first contribution to the fund is treated as a taxable distribution that is not eligible for rollover other than to another SIMPLE IRA. They cannot be converted to a Roth IRA.

8. The 10% penalty trap

There's a 10% early withdrawal penalty when funds are withdrawn from an IRA before age 591/2, but the Roth conversion is an exception and one of the reason many people are drawn to it.

However, two tax traps can still trigger the 10% penalty. One of these traps is if some (or all) of the funds withdrawn are used to pay the conversion tax which could be high and many people may not have change to pay the taxes on the amount converted and are planning to use the money from the fund to pay the taxes.The second trap occurs when funds converted to the Roth are withdrawn within the first five years and the Roth IRA owner is still under age 591/2.

9. Rolling to an IRA in middle of Year:

If you plan to roll your 401(k) into an IRA in the same year that you do the conversion, be sure to avoid this trap.If your IRA is converted only IRA assets are taken into consideration for the pro-rata rule, and not the plan asset. What it means that consider the case where someone has an IRA worth $20,000, of which $10,000 is non-deductible contributions and $10,000 is earnings with pretax 401K of $50,000. If this person converts the entire IRA, he will owe tax only on $10,000 since the plan assets in 401K are excluded from the pro rate formula.

10. Required Minimum Distributions must be taken

Many people are interested in converting to Roth as so they could convert and stop taking those tax-causing Required Minimum Distribution, so they are very eager to do this convertion. In their haste to convert, some IRA owners might convert their entire account balance not knowing that their Required Minimum Distributions cannot be converted to Roth. For Individuals who are 701/2 or older in 2010 must first take their 2010 RMDs if they plan to convert all their IRAs to Roth IRAs.

There might be more issues based on your individual money and plan you have with either 401K or Traditional IRAs. Know all your facts before you convert your hard earned income to lose it in more taxes.