Retirement plans -- IRAs, SEPs, Roths, 401(k), -- can seem like alphabet soup and confuse beginning investors. Keeping track of the different type of retirement accounts can be difficult, let alone getting the tax rules for each one straight. Because of this, some investors mistakenly believe they qualify for a tax credit when converting a pretax retirement account to a Roth. In some cases, investors can claim a credit for new – non-rollover – Roth contributions, but rollovers never qualify investors for a tax credit.
Roth Contribution Credit
In order to spur savings in workers with lower annual earnings, the Internal Revenue Service allows some investors to claim a deduction based upon the first $2,000 they contribute to a Roth retirement account. Workers who are single and earn $16,000 or less, or joint filers with combined income of $32,000 or less may claim a 50 percent credit on the first $2,000 contributed to a retirement account. The credit phases out for those who earn more than $26,500 or $53,000 if married. This credit may only be claimed on new contributions, not on rollover funds.
Taxes on Roth Conversions
In most cases, investors who perform rollovers from traditional IRAs face additional taxes, not a tax credit, for the reorganization of their retirement funds. Funds placed in a qualified retirement account on a pretax basis, such as the first $5,000 each year placed in an IRA, aren’t taxed at the time they’re earned. This applies to rollovers to post-tax retirement accounts such as Roth IRAs. Investors who perform a rollover should be prepared to pay income taxes according to their marginal rate -- which may increase if they roll over a large amount in a single year.
Paying for Conversions
It may be tempting to turn to the funds rolled over in a Roth conversion to help cover a tax bill, but that strategy is costly. Investors who tap into retirement funds to pay the IRS face a 10 percent early-excise penalty on all funds they withdraw during the rollover, if they’re not age 59 1/2 when they make the rollover. The IRS levies these fines in addition to normal income taxes, so even investors with modest incomes who are in the 25 percent tax bracket face a 35 percent tax rate on funds used this way.
Mulitple IRAs and Conversions
The IRS requires investors who hold multiple traditional IRAs who only want to roll over portions of their IRAs to take money from each one proportionately, instead of closing one down and rolling over its funds to a Roth. For example, an investor who holds two IRAs valued at $100,000 and $50,000, and who wants to convert $50,000 to a Roth, would need to take $16,500 from the smaller IRA and $33,500 from the larger to maintain a proportionate rollover.