The money that you invest in a Roth individual retirement account, or IRA, grows tax-deferred in the same way that money grows inside a traditional IRA. However, Roth IRAs provide you with the opportunity for tax-free income, while traditional IRAs provide you with taxable income during your retirement years. By moving money from a traditional IRA to a Roth you can potentially reduce your long-term tax liability and you also avoid having to make mandatory IRA withdrawals.
You can deduct your traditional IRA contributions from your taxable income, which means that you avoid paying tax on your principal and your IRA earnings until you make a withdrawal from the account. You fund a Roth IRA with your already taxed net earnings but if you keep the money in the account for more than five years and make no withdrawals before reaching age 59 1/2, then you pay no income tax on your withdrawals. The Internal Revenue Service imposes income restrictions on Roth contributions, with the result that many high-earners cannot take advantage of these accounts. However, regardless of your income level, you can convert a traditional IRA to a Roth by paying income tax on the sum of money that you convert.
If you have $100,000 in your IRA and expect your IRA to double in value by the time that you retire, then you would pay ordinary income tax on on the gradual withdrawal of $200,000. If you pay income tax at a 25 percent rate then you would end up paying $50,000 in taxes. If you convert your traditional IRA to a Roth, then you pay $25,000 in taxes now but pay no tax on future withdrawals from the Roth. If tax rates rise, then you save even more money by converting. But if tax rates drop, you may not necessarily make a saving.
Required Minimum Distributions
When you reach the age of 70 1/2, you must start taking required minimum distributions from your traditional IRA, even if you have yet to retire. RMDs are based upon life expectancy and you pay a penalty equal to 50 percent of your RMD if you do not make the withdrawal. Since Roths contain already taxed funds, the RMD rule does not apply to Roth IRAs. This means that you do not have to make Roth withdrawals until you actually need your money. In fact, you can leave your money in your Roth IRA for life and pass the tax-free earnings onto your heirs.
If you have an emergency and need to access funds from your traditional IRA, you normally have to pay income tax on the withdrawal and if you have not reached the age of 59 1/2, you also pay a 10 percent early withdrawal penalty. If you withdraw money from your Roth, withdrawals are based on the first-in-first out basis. This means that you withdraw your principal before you withdraw your earnings so you only pay tax or the tax penalty if you withdraw more than you invested in the account. Therefore, a Roth conversion provides you with the ability to make future penalty free withdrawals as and when you need to.
- IRS.gov; 2011 Contribution and Deduction Limits - Amount of Roth IRA Contributions That You Can Make For 2011; November 2010
- Smart Money; Roth IRA Conversions: Still Smart?; April 2011
- IRS.gov; Retirement Plans FAQs Regarding IRAs; July 2011
- American Bar; The Benefits of Roth IRA Conversions; Keith Martinet; April 2006
- Merrill Lynch: Roth IRA Conversion
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