Individuals with earned income can contribute to an individual retirement account (IRA) up to a maximum limit each year. In certain cases, plan holders can transfer, or roll over, funds from one IRA to another. Rolling over a traditional IRA to a Roth IRA is a common transfer, but the benefits must outweigh the tax consequences.
Traditional IRAs versus Roth IRAs
A traditional IRA provides an investor with a tax deduction when contributions are made to the plan. When funds are withdrawn in retirement, they are taxed at the taxpayer's marginal tax rate. If the funds are withdrawn prior to the individual turning 59 1/2 years old, the IRS assesses a 10 percent penalty on amounts withdrawn. A Roth IRA doesn't give a tax break when contributions are made, but the income is never taxed, even when withdrawn.
Reasons to Roll Over
The IRS has provisions for transfers of retirement savings from a traditional IRA to a Roth IRA. The biggest reason for wanting to make such a transfer is to shelter high-income producing retirement assets from taxes. This is especially the case with capital gains, which would otherwise be taxed higher in a traditional IRA than they would if held outside of a retirement plan. Rolling over a traditional IRA to a Roth IRA doesn't make sense immediately after the contribution to the former. There is no benefit to the transfer that would not have been accomplished by contributing directly to a Roth IRA in the first place.
Because contributions are tax-deductible, they must be taxed when withdrawn or transferred to another type of plan. Legitimate rollovers will not incur the early withdrawal penalty, however. You can either have your plan administrator roll the funds directly between plans, or withdraw the funds yourself. If you then contribute them to a Roth IRA within 60 days, you will not incur the 10 percent penalty. If you contribute to a traditional IRA and rollover in the same year, you will have both a tax deduction for the contribution and taxable income for the withdrawal. These will essentially cancel each other out. If you contribute one year and rollover in a later year, you are basically borrowing the tax refund, but will need to pay tax in the rollover year.
Some IRA administrators charge fees on a rollover, and these fees can make transfers unattractive in the short term. However, the long-term benefits of having tax-free income in the future may outweigh this issue.
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