Individual retirement accounts are designed to help workers invest their money to provide financial security once they reach retirement age. Different IRA types carry different tax benefits to help the account holder better manage his retirement planning. In some cases, it may be beneficial for a person to invest a traditional IRA and then convert it to a Roth IRA soon after the investment is made.
Traditional IRAs vs. Roth IRAs
Traditional IRAs are not taxed while they are held so long as no money is removed from the account; provided that no money is distributed early, the only time that these IRAs are taxed is when distributions are taken at retirement. The IRS does not limit the amount that can be invested in a traditional IRA during the course of a tax year. Contributions to Roth IRAs, on the other hand, are made with after-tax dollars, so withdrawals are tax-free in retirement. Unlike traditional IRAs, the IRS does place limits on yearly Roth contributions based on income.
Traditional IRAs can be converted to Roth IRAs by taking a special distribution known as a rollover from the traditional IRA and depositing it into the Roth IRA. The trustee who manages the traditional IRA can also transfer the funds directly to the manager of the Roth IRA, or handle the transfer completely if it is trustee for both accounts. A single trustee may also be able to redesignate a traditional IRA to a Roth IRA without the need for a second account to be open.
Qualifying for Conversion
A traditional IRA can be converted to a Roth IRA so long as the amount converted is not due as a scheduled withdrawal in a specific year, such as the year the account holder reaches retirement age. If the conversion is made using a distribution from the traditional IRA instead of a direct transfer, the Roth contribution must be in the same form as the distribution withdrawal and must be made within 60 days. The conversion is not subject to contribution limitations that would otherwise be placed on a Roth IRA and is not subject to the one-year waiting period that would otherwise be associated with distributions.
When converting a traditional IRA to a Roth IRA, the amount distributed in the conversion must be claimed as income on the account holder's taxes. For the 2010 tax year the IRS allows this claim to be divided between two tax years, though the account holder may choose to claim the distribution in a single tax year if desired. The amount is taxable as income and standard fines apply for nonpayment of any taxes due on the conversion.
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