The Individual Retirement Agreement is a popular way for investors to save for retirement while also taking advantage of the IRA's tax-friendly status. There are two kinds of IRAs, traditional and Roth IRAs. Traditional IRA owners can convert to Roth IRAs if they choose. Although prior income rules restricted who could and couldn't convert to Roth IRA, the restriction was suspended in 2010. Keep in mind that Roth conversions require paying income taxes on the transferred balance, and where you live strongly affects how much in state taxes you'll pay.
How Conversions Work
When converting a traditional or Simplified Employee Pension, or SEP, IRA to a Roth IRA, technically you're receiving a distribution. You'll have 60 days to open a new Roth account, and if you don't, you'll be hit with a 10 percent penalty, in addition to federal and possibly state income taxes. In the past, only IRA owners who earned less than $100,000 could convert to a Roth, but that changed in 2010; now all IRA owners can convert. When you file your income taxes, you'll be required to report the conversion and pay taxes on the transferred balance (if taxes weren't taken out already when you made the conversion).
Depending upon where you live, you may or may not have to pay state taxes on your Roth conversion. If your state taxes retirement distributions, then you'll have to pay income tax. According to Kiplinger, residents of Alaska, Florida, Nevada, New Hampshire, Pennsylvania, South Dakota, Tennessee, Texas, Washington and Wyoming won't have to pay state income taxes on IRA distributions. In addition, some states offer a partial exclusion on retirement income, and married couples may get a bigger exclusion than single individuals.
The federal government taxes traditional IRA owners who convert to Roth IRAs because these owners earned a tax deduction when they contributed to their traditional IRA accounts. How much federal tax you owe on your conversion depends on your income, and in 2011 your contribution and appreciation tax rate could be as high as 35 percent. Bankrate recommends that young investors who may not have big account balances and who also have a lot of time to let their earnings grow may be the best suited for conversion.
The Internal Revenue Service has provided traditional IRA owners with a three-year suspension period during which any owner can convert to the Roth, regardless of income. Also, if you're considering converting but have plans to move to a different state, it may be worth it to wait on the conversion if the state you're moving to doesn't tax IRA investments or income taxes. Perhaps most importantly, don't hesitate to speak with a tax professional about your specific situation. Just be sure that the person you choose is well-versed in the IRA tax rules in your state.
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