Roth IRA Conversions
Roth IRA conversions may seem like a good choice for many individuals, because of the tax advantages that this type of retirement account can offer. In some cases this conversion can be a poor choice though. In some situations the end result of a conversion could be a significant loss of retirement savings instead of benefits.
A Roth IRA conversion occurs when an account holder with a traditional IRA converts the account balance to a Roth IRA instead. A conversion may or may not be possible, even if the individual is eligible to open a new Roth IRA. The income limits applied to Roth IRA conversions are typically lower than the limit to set up an account of this type. Other factors also help determine whether a conversion is possible, such as filing status, income cap, and annual income amount.
Just because it is possible to convert a traditional IRA into a Roth IRA does not mean that it is a good financial move for everyone. It is important to remember that Roth IRA contributions must be made with earnings that have already been taxed. A traditional IRA takes earnings before taxes and then tax is paid on the withdrawals from the account. A Roth IRA allows tax free withdrawals as long as the IRS requirements are met because the account funds have already been taxed.
The difference in tax structures usually mean that Roth IRA conversions come with a significant tax bill. The funds converted from the traditional IRA must be taxed before the money can be contributed to a Roth IRA. This eliminates any possibility of avoiding taxes on the money. Taxes must be paid on any pre tax contributions being converted as well as any IRA earnings up to the conversion date.
It is a mistake to assume that any tax liability can be taken from the traditional IRA account balance, and these taxes need to be paid before the funds are placed in the Roth IRA. If the taxes are withdrawn from the IRA account to pay the IRS and the account owner is not the minimum required age of 59 ½ for withdrawals then the 10% early withdrawal penalty will apply.
There is another consideration that also needs to be evaluated with Roth IRA conversions. When the conversion occurs then the amount of income generated will be included in the annual earnings. This can cause the account owner to end up in a higher tax bracket which is subject to a higher tax rate. In addition this income increase can also affect any tax credits and benefits available, including the college tuition tax credits and dependent child credits as well as a number of others.
The age of the account holder also plays a part in Roth IRA conversions. This step may make sense for individuals who still have a significant amount of time to make contributions. For individuals close to the required withdrawal age of 59 ½ this conversion may not be such a good idea because of the significant costs involved.
