There are many benefits of transferring funds from traditional individual retirement accounts (IRAs) to Roth IRAs. Each has its own set of tax rules on contributions and withdrawals, and there are tax consequences to transferring from one to the other. The long-term savings in taxes must be worth more than the current tax burden of the transfer for it to make financial sense.
Traditional vs. Roth
Traditional IRAs allow for a tax deduction for contributions up to the annual limit, and the income and contributions don't become taxable until withdrawn when you're retired. This allows for tax deferral for potentially decades. If the taxpayer's tax rate in retirement is lower than during his working years, which is often the case, there will be a partial permanent tax avoidance. With a Roth IRA, the contributions are made after-tax, but both the contributions and income built up in the plan are tax free when withdrawn. This means the income in the plan is never taxed, whereas, in a traditional IRA, the income will be taxed as ordinary income regardless of whether it is dividends, interest or capital gains.
Limits on Conversion
As of 2010, the income limit on transferring funds from a traditional to a Roth IRA has been permanently lifted. This means that anyone can make the transfer. Although there are annual contribution limits to IRA plans, there is no limit on rollovers, so you can transfer part of a traditional IRA or all of it into a Roth IRA.
Rules of Conversion
Because contributions to a traditional IRA are tax advantaged going in, they must be taxed on withdrawal -- even on a rollover to a Roth IRA. In 2010, a special tax provision allowed the tax hit to be spread over 2011 and 2012; however, in all other years, the entire rollover amount is taxable in the year withdrawn. The funds can then be rolled into a Roth IRA and will never be taxed again. This significant tax burden requires careful forethought and planning in conjunction with a tax accountant to ensure that the benefits of the conversion will outweigh the tax consequences.
What to Hold
You can still have both a traditional IRA and a Roth IRA -- it doesn't have to be one or the other. Because of the tax implications, it makes sense to hold capital gain producing assets in the Roth IRA, and interest and dividend producing assets in a traditional IRA. Capital gains have a favorable tax rate if held outside a retirement plan. Therefore, they would be taxed at a higher rate if held in a traditional IRA because all income is taxed as ordinary income. The tax benefit of accumulating capital gains only happens in a Roth IRA where the gains are never taxed.
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