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A Roth IRA is a retirement savings vehicle like no other. Not only can account holders withdraw their contributions at any time without taxes or penalties, but also these accounts aren't subject to required minimum distributions (RMDs)—and all earnings are tax-free.
Investors who feel they are too heavily steeped in pre-tax retirement contributions may decide to convert some traditional IRA contributions into a Roth, repaying any tax credits received for the contributions while allowing future gains to grow tax-free.
However, the Roth conversion process can sometimes be complex, and a misstep can cost you money in taxes, fees, and penalties. How does a Roth conversion work, and what should you know before getting started?
What Is a Roth IRA Conversion?
A Roth conversion involves transferring pre-tax or tax-deferred retirement assets (from a traditional, SIMPLE, or SEP IRA) into a Roth IRA. This creates a taxable event, which means that you will likely owe taxes on the amount converted in the year of conversion—but after that, these contributions are treated as though they had originally been put into a Roth in the first place. You also shouldn't owe any early withdrawal penalties, as the conversion simply moves these assets from one retirement account to another. When you reach retirement age, you can withdraw any earnings and contributions without paying a dime of tax.
How Are Roth Conversions Executed?
The IRS has described three different ways to convert a traditional IRA to a Roth.1
- A rollover allows you to take a distribution from your traditional IRA—usually by check or online transfer—and move that money into your Roth within the next 60 days.
- A trustee-to-trustee transfer requires you to instruct the financial institution that holds your traditional IRA to transfer these funds to a different institution that holds your Roth IRA.
- A same-trustee transfer is like a trustee-to-trustee transfer, but transfers the funds within the same institution. If you don't already have a Roth IRA, a same-trustee transfer allows you to open one during the conversion process.
Each method comes with its own advantages and disadvantages. A rollover is perhaps the riskiest; if something comes up and you don't deposit the traditional IRA distribution within 60 days, this distribution will be treated as an early withdrawal and is subject to taxes and penalties. With so many banking and investment services available online, either of the trustee transfer options will essentially just require you to click a few buttons.
When you file your tax return for the year in which the conversion took place, you'll need to report it to the IRS on Form 8606. Otherwise, you run the risk of this transfer being misclassified, which can impact both your income taxes and your ability to withdraw funds from the IRA in the future.
A Roth conversion may not be right for every financial situation. But for some, it might be a great way to reduce future taxes and improve the flexibility of your retirement finances.
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Contributions to a traditional IRA may be tax deductible in the contribution year, with current income tax due at withdrawal. Withdrawals prior to age 59 1/2 may result in a 10% IRS penalty tax in addition to current income tax.
The Roth IRA offers tax deferral on any earnings in the account. Withdrawals from the account may be tax free, as long as they are considered qualified. Limitations and restrictions may apply. Withdrawals prior to age 59 1/2 or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRAs. Their tax treatment may change.
Traditional IRA account owners should consider the tax ramifications, age and income restrictions in regards to executing a conversion from a Traditional IRA to a Roth IRA. The converted amount is generally subject to income taxation.