A Roth IRA conversion is when an investor transfers funds from a traditional IRA to a Roth IRA, paying ordinary income tax on the transfer. After conversion, funds in the Roth IRA are tax-free if not withdrawn early. Taxpayers can potentially reduce their tax burden by converting traditional IRA funds to non-taxable Roth accounts. Income limits apply, but the IRS temporarily eased restrictions in 2010. However, tax brackets change regularly, and a Roth IRA conversion may not always benefit investors.
A Roth Individual Retirement Account (IRA) conversion occurs when an investor in the United States transfers funds from a traditional IRA to a Roth IRA. When an investor makes a Roth IRA conversion, the Internal Revenue Service (IRS) requires the investor to pay ordinary income tax on the funds transferred. After a Roth IRA conversion, the investor does not have to pay taxes on the capital or earnings in the Roth IRA, provided the funds are not withdrawn within five years or before the investor reaches the age of 59½. Individuals who prematurely access funds from a Roth IRA or Traditional IRA face a 10% tax penalty.
The IRS allows taxpayers in the United States to set aside retirement money in IRA accounts. Funds within IRA accounts increase tax deferred. Traditional IRAs are funded with pre-tax earnings, and as a result, both principal and earnings are fully taxable when the investor makes withdrawals. Withdrawals from Roth IRAs are not subject to tax because the accounts are funded by after-tax earnings.
Investors can potentially reduce their tax burden by using a Roth IRA conversion to move already accumulated traditional IRA funds into non-taxable Roth accounts. The investor pays ordinary income tax on conversion, but thereafter gains in the account are not taxable. People who leave funds in a traditional IRA ultimately have to pay taxes on the capital and all future earnings.
The IRS only allows taxpayers earning below certain thresholds to move funds from a traditional IRA using a Roth IRA conversion. The income limits for these operations are determined on an annual basis. During 2010, the IRS temporarily eased income restrictions and allowed all taxpayers to convert IRAs regardless of income.
Tax brackets change regularly, so some tax experts argue that a Roth IRA conversion doesn’t necessarily benefit an investor since conversions are usually made with the assumption that future taxes will be higher. Many people find themselves in lower tax brackets when they retire, so the taxes they owe on a traditional IRA withdrawal are often less than they would have had to pay to access the funds during their working years when they make a Roth IRA conversion. In a down market many investors experience minimal growth on their investments and there is no tax benefit to a Roth conversion if the invested assets do not continue to grow.
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