IRA Rollover

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Question: Should I convert my Rollover IRA to an existing Roth IRA?

I currently have two IRAs, a Rollover IRA worth $7,100 and a Roth IRA worth $1,000. They are both at the same brokerage.

Is it wise for me to convert my Rollover IRA to my current Roth? What kind of penalties and taxes will I have to pay? Is there a better way to minimize taxes? Should I have the tax withheld or should I pay from the taxes/penalty from an outside source rather than from the IRA?

My current gross income is around 45k and in the 25% tax bracket.

Answer: Here’s the situation:

1. Converting to a Roth does not have a penalty. All you will owe is income tax on that money, so….

$7100 x 25% (your tax bracket) = $1775 extra taxes you will owe

2. It does make sense to convert this if…
a. you have enough money to cover the tax bill
b. you expect your tax rate to rise in the future (in other words, when you retire, you think your tax rate will be higher than it is now
c. you want a source of tax free money when you retire

3. Another strategy is this: you could convert a portion each year. Since this money is taxed as ordinary income, you could convert a small amount each year so it doesn’t bump you into a higher tax bracket. Also this strategy would ensure that you are not shocked by your higher tax bill at year end

4. Once you make over $100,000, you are no longer eligible to convert (this law is changing in 2010)

5. DO NOT, I REPEAT DO NOT WITHHOLD TAXES! take care of them yourself at year end. The reason for this is the following: if you convert lets say $5000 and withhold 20% or $1000, the $1000 withheld goes straight to the federal government. Well, guess what? Since that money did not go into the Roth, the withholding itself is now subject to taxes PLUS a 10% penalty. Very bad deal.

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