Although most people deduct their contributions to a traditional IRA, some people cannot, or choose not to. Instead, they make after-tax traditional IRA contributions. However, if your traditional IRA contains after-tax contributions, you may want to consider converting it to a Roth IRA instead.
The IRS permits conversions from traditional IRAs to Roth IRAs regardless of whether the traditional IRA contains after-tax contributions. In fact, some people who cannot contribute to a Roth IRA, but would prefer to save on an after-tax basis, simply make a nondeductible contribution to a traditional IRA and then convert the money to a Roth IRA. As of 2011, the IRS places an income cap on who can convert from a traditional IRA to a Roth IRA.
Cannot Convert Only After-Tax Contributions
When you convert money from a traditional IRA to a Roth IRA, you cannot pick and choose which parts of the account you want to convert. If you convert the entire account, both the after-tax portion and the pretax portion will be converted, but you will only pay income taxes on the pretax portion. If you convert part of your account, the converted amount will be divided into an after-tax part and a pretax part based on the portions each type makes up in your account. For example, if 60 percent of your IRA's value equals after-tax contributions, 60 percent of whatever amount you convert to a Roth IRA will consist of after-tax contributions.
Advantages of Converting
By converting a traditional IRA to a Roth IRA, you ensure that when you take distributions, both the after-tax contributions as well as earnings come out tax-free. If you were to leave the money in a traditional IRA, you would still be able to take out the after-tax contributions without being taxes, but the earnings would be fully taxable. In addition, you can leave the money in the Roth IRA as long as you want because Roth IRAs are exempt from minimum required distributions.
Need Money for the Conversion Taxes
Before converting money from a traditional IRA to a Roth IRA, make sure you have enough money to cover the extra taxes you incur. Unless you have no earnings in the traditional IRA, you will incur some income tax liability when you convert. By saving extra cash to pay the income taxes, rather than using some of the conversion money, you avoid shrinking your nest egg. You also avoid paying the early withdrawal penalty that you would have to pay if you are under age 59 1/2 when you make the conversion.
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