A Roth IRA conversion involves transferring funds from a traditional IRA to a Roth IRA, with the investor paying ordinary income tax on the transferred funds. After the conversion, the investor does not have to pay taxes on the principal or earnings in the Roth IRA. However, there are income limits for these transactions, and tax brackets can change, making a Roth IRA conversion not always beneficial.
A Roth IRA conversion occurs when an investor in the United States transfers funds from a traditional IRA to a Roth IRA. When an investor performs a Roth IRA conversion, the IRS requires the investor to pay ordinary income tax on the transferred funds. After a Roth IRA conversion, the investor does not have to pay taxes on the principal or earnings in the Roth IRA, as long as the funds are not withdrawn within five years or before the investor turns 59½. People who access funds from a Roth IRA or traditional IRA prematurely have to pay a 10 percent tax penalty.
The IRS allows taxpayers in the United States to set aside money for retirement in IRAs. Funds inside IRAs grow tax-deferred. Traditional IRAs are funded with pre-tax earnings, and as a result, both the principal and earnings are fully taxable when the investor makes withdrawals. Roth IRA withdrawals are not taxed 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 at the time of conversion, but thereafter the gains in the account are not taxable. People who leave funds in a traditional IRA eventually have to pay taxes on the principal as well as all future earnings.
The IRS only allows taxpayers earning below certain thresholds to move funds from a Traditional IRA through a Roth IRA conversion. The income limits for these transactions are determined annually. During 2010, the IRS temporarily relaxed income restrictions and allowed all taxpayers to convert IRAs regardless of income.
Tax brackets change on a regular basis, so some tax experts argue that a Roth IRA conversion doesn’t necessarily benefit an investor, as conversions are typically made on the assumption that future taxes will be higher. Many people are in lower tax brackets when they retire, so the taxes owed on a traditional IRA withdrawal are often less than they would have had to pay to access the funds during their working years by converting from Roth IRA. In a down market, many investors experience minimal growth in 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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