Posted on: Thursday, June 2, 2005

AKAMAI MONEY
Rolling over traditional IRA into a Roth is tricky

By Deborah Adamson
Advertiser Staff Writer

Q: I am planning to convert my traditional IRA to a Roth IRA. I have put $10,000 in my traditional IRA, but the value of the fund is now $7,000. I know that I have to pay taxes on the IRA when I roll it over into the Roth. But since there was a loss of $3,000, can I deduct this as an investment loss on my income taxes? Also, do I pay taxes on the amount of money I put into the traditional IRA or on the value of the IRA at the time of the rollover into the Roth?

— Dr. Dexter Seto, Kapolei

A: The answer depends on whether you have deductible or nondeductible contributions to an individual retirement account, or IRA.

A deductible IRA contribution is one in which your deposits into a traditional IRA are tax deductible because you meet income restrictions and other IRS conditions. You don't get a tax break with nondeductible IRA contributions.

Roth criteria

If your contributions were deductible, the money in the account has not been taxed. That means if you convert the account into a Roth IRA, you'll have to claim the $7,000 as additional income for the year and pay taxes on it, said Marilyn Gagen, a certified public accountant in Honolulu and past president of the Financial Planning Association, Hawai'i chapter.

"You just pick up the income of $7,000 instead of $10,000. You can't deduct the loss," she said.

If you have nondeductible IRA contributions and wish to convert to a Roth, you can deduct the $3,000 loss, Gagen said. That's because the nondeductible contributions have been taxed, so you can take the loss. You claim the loss as an itemized deduction, subject to certain limits. But you must withdraw all your money from the nondeductible IRA to take the loss.

For more information, go to www.irs.gov and do a search for Publication 590.

But make sure you qualify to convert to a Roth IRA, said Lesley Brey, a fee-only certified financial planner in Niu Valley. The Roth IRA is similar to a traditional IRA except that deposits are not tax-deductible and withdrawals are tax-free. To qualify for a Roth conversion, you need to have a modified adjusted gross income of $100,000 or less in the year you convert, and you must not be a married person filing a tax return separately.

Which IRA suits you?

Should you convert to a Roth?

It depends on when you'd need the money. Convert if you don't need to tap into the funds for 15 to 20 years, Brey said.

If you'll need the funds soon, such as if you're nearing retirement, it makes less sense to convert since you'll pay taxes in the conversion and there's also a 10 percent penalty for withdrawals within five years of opening the account. Also, your tax rate after retirement might be lower, so consider sticking with your traditional IRA.

However, if you're a senior but the IRA will be given to your heirs, consider converting. Pay the taxes now and let the money grow tax free, Brey said. Don't convert only if you believe the heir will stay at a low income tax bracket.

Got a consumer or personal finance question? Reach Deborah Adamson at dadamson@honoluluadvertiser.com or 525-8088.