One of the long-term financial planning tactics that many have adopted is rolling a Traditional IRA into a Roth IRA.
A few years ago, the income restrictions on rolling an existing tax-advantaged account to a Roth IRA were lifted. As a result, it’s possible for almost anyone to take advantage of a Roth IRA since it’s possible to open a Traditional IRA, and then roll it over.
However, it’s not a straight transfer, since the benefits of a Traditional IRA and a Roth IRA are different. With a Traditional IRA, you make contributions with pre-tax dollars. With a Roth, your contributions are made after-tax. So, if you roll over your Traditional IRA, Uncle Sam wants you to pay taxes on it – since with the Roth you don’t pay taxes when you withdraw.
Paying Taxes on Your Rollover Amount
When you decide to roll over your Traditional IRA to a Roth, you will need to count the money as part of your income. Income is reported as the value of the funds you are rolling over on the day you convert. So, if you have seen some gains, you will be taxed on them as well.
Because the rollover funds are taxed as regular income, you will need to plan for this. Not only will you pay taxes on the amount you roll over, but you might also be bumped up into another tax bracket. Realize that, since the income is reported on your tax form, you can take deductions and credits to help reduce the blow (although in some cases the income puts you at phase-out levels for some tax breaks).
In order to spread out the impact, some investors choose to roll over parts of their IRA a little at a time, spacing it out. You don’t have to roll over everything all at once, though.
Make sure that you complete the rollover within the designated time frame, though, or you could end up being subject to a 10% penalty for early withdrawal.
The best way to accomplish a rollover is to use the help of a trustee to trustee transfer (making sure to designate that you are rolling over the funds) so that the money goes straight from one custodian to another. If you have to withdraw the money, and then roll it over yourself, it can be a good idea to get help from a professional to make sure you follow the steps to avoid a 10% penalty from the IRS.
Does a Roth IRA Conversion Make Sense for You?
Before you roll your money over, consider whether or not a conversion makes sense to you. Many investors choose to roll over to a Roth because the money in a Roth grows tax-free. You may pay taxes now, but when you withdraw, you don’t have to pay taxes – and you won’t pay taxes on your earnings.
For some, especially those who think that their taxes will increase in the future, it makes sense to pay taxes now, at a lower rate, and then avoid paying taxes on the money later on.
If you think that you can save on taxes in the long run, and if you can handle the potential increase in your tax bill right now, you might consider rolling over to a Roth IRA.