Individual retirement accounts (IRAs) provide a means of saving money for retirement. A traditional, IRA is funded using money that you earn through employment. These funds come out of your paycheck prior to taxes being taken out. A Roth IRA, on the other hand, is funded by income that has already been taxed.
Because a traditional IRA is funded with pretax dollars, it takes less income to build your savings more quickly. For example, if you have $2,000 to invest per year, you can put the entire $2,000 into a traditional IRA, and that money goes in tax free. If you used the same amount to fund a Roth IRA, you would be taxed first. So if your tax rate is 20 percent, you would have to pay $400 in taxes and end up with only $1,600 in the Roth IRA account. Traditional IRAs are also more commonly offered directly through an employer.
The fact that a Roth IRA is funded after taxes has both advantages and disadvantages. Although it may take longer to reach the same level of savings in a Roth IRA account, those contributions are not subject to taxes when you withdraw the money. Withdrawals from a traditional IRA that was funded pretax, however, is taxed at whatever your tax rate is when you withdraw the money. You can also withdraw the contributions that you make to a Roth IRA at any time without penalty, while early withdrawals from a traditional IRA come with additional fees.
If you want to roll a traditional IRA into a Roth IRA, you must pay the taxes on the money that you roll over into the Roth IRA in the same tax year in which you roll the savings over. To declare the rollover, add the amount of money that you rolled over from the traditional IRA into the Roth IRA to your regular income for the year. For example, if you make $20,000 through employment, and rollover $5,000 from a traditional IRA into a Roth, you must list your income as $25,000 and will be taxed on the total amount.
When rolling over a traditional IRA into a Roth IRA, make sure that you do so through a reputable financial institution to avoid penalties. Do not simply withdraw the money from the IRA to fund the Roth IRA. If you withdraw the money from an IRA before you are 59 1/2 years old, you will be subject to income tax on the money, and a 10 percent penalty fee on the withdrawal.