What is a Roth IRA Conversion?
A Roth Individual Retirement Account (IRA) conversion occurs when an investor in the U.S. transfers funds from a Traditional IRA into 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the investor does not have to pay tax on the principal or earnings in the Roth IRA, as long as funds are not withdrawn within five years or prior to the investor reaching age 59 and a half. People who access funds from a Roth IRA or a Traditional IRA prematurely have to pay a 10 percent tax penalty.
The IRS allows taxpayers in the U.S. to set money aside for retirement in IRA accounts. Funds inside IRA accounts grow tax deferred. Traditional IRAs are funded with pre-tax earnings, and as a result both the principal and the earnings are fully taxable when the investor makes withdrawals. Withdrawals from Roth IRAs are not subject to taxation because the accounts are funded with 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 does pay ordinary income tax at the time of the conversion, but thereafter the account earnings are non-taxable. People who leave funds in a Traditional IRA eventually have to pay taxes on the principal as well as on all future earnings.
The IRS only allows taxpayers earning below certain thresholds to move funds from a Traditional IRA using a Roth IRA conversion. Income limits for these transactions are determined on an annual basis. During 2010, the IRS temporarily relaxed the 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 does not necessarily benefit an investor since conversions are usually made on the assumption that future taxes will be higher. Many people are in lower tax brackets when they retire, so the taxes due on a Traditional IRA withdrawal are often less than they would have had to pay for accessing funds during their working years when making 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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