Not everyone who has an IRA is aware of their ability to convert a traditional IRA or employer-sponsored retirement plan to a Roth IRA. The truth is, making the conversion is quite simple, especially if you understand how to make the conversion. You decide whether to transfer all of your existing retirement account balance to your new Roth IRA or just a portion. Here is what you need to know.
How IRAs work in general
An Individual Retirement Account, or IRA, is basically an investment account that provides tax advantages along with a reliable way to save money for retirement. IRAs do not require you to pay taxes on the investment earnings from the account. Instead, these earnings can be reinvested and compounded so that your account will experience as much growth as possible. Then, after you reach retirement age and start making withdrawals from your IRA, the tax consequences depend on three factors. Those factors include the type of IRA you have, your present income and the amount of your withdrawals.
The different types of IRAs available
There are basically four different kinds of IRAs, each with its own advantages. Traditional IRAs and Roth IRAs are opened by individuals, as opposed to Simplified Employee Pension (SEP) and a Savings Incentive Match Plan for Employees (SIMPLE) are made available through employers. Regardless, all IRAs are considered “fully vested.” This means that all contributions and earnings belong to the individual, even those contributions made by their employers.
Why should you convert to a Roth IRA?
Converting to a Roth IRA can be an attractive option, especially if you expect your tax rate to increase in the future. Another benefit is that, when your earnings are too high to allow you to contribute to a Roth IRA directly, you may be able to use a Roth conversion as another means to provide tax free retirement income.
When should I convert to a Roth IRA?
Typically, those whose income is too high to contribute to a Roth IRA in a particular year, but who anticipate being in a higher tax bracket when they retire, benefit the most from converting to a Roth IRA. Something else to consider is how much you intend to convert, in addition to your income for the current year. You need to make sure the combined amount will not result in a substantial tax burden. If the conversion results in placing you in a higher tax bracket or subjecting you to additional taxes then it may not be the best idea.
How the conversion to a Roth IRA is made
The easiest way to convert is by making a direct trustee-to-trustee transfer from one financial institution to another. If you intend to keep the retirement account at the same investment firm, on the other hand, you can request that your traditional IRA be re-designated as a Roth IRA, as opposed to opening a new account. You can do the same thing with a 401(k) or an employer-sponsored plan. However, be sure that the funds are transferred directly from one financial institution to the other.
A few requirements to remember
If you are issued a check for the funds, you are required to withhold 20% of the amount for tax purposes. But, as long as you deposit all of the money, including the 20%, into a new Roth account within 60 days there will be no penalty. If you can’t make the deadline, any funds that are not rolled over in a Roth IRA are subject to the 10% early withdrawal penalty if you are younger than age 59 1/2. The penalty is imposed in addition to the income taxes.
What makes a Roth IRA different?
IRAs have eligibility requirements based on the income of the account holder. In order to make contributions to a Traditional IRA, you must have earned income and be younger than 70 ½-years-old. On the other hand, a Roth IRA only allows contributions by individuals whose income falls within certain limits. Earned income refers to the money you are paid to work, including wages, salaries, tips, bonuses, commissions, and self-employment income.
Different in tax incentives for traditional and Roth IRAs
Traditional IRA contributions are tax deductible on both the state and federal level. The deductions must be made during the year the contribution is made. But, withdrawals made during retirement are taxed at the ordinary income tax rates. Roth IRAs, though, do not offer a tax break on contributions. Instead, the withdrawals and earnings are basically tax-free. In other words, you can avoid taxes when you put money into a traditional IRA, and you avoid taxes when you take money out of a Roth IRA during retirement.
If you have questions regarding your planning needs, contact the Northern California Center for Estate Planning and Elder Law for a consultation, either online or by calling us at (916) 437-3500.