Tax Consequence for a Transfer From a Traditional IRA to a Roth
Original post by Chris Blank of Demand Media
In planning for retirement, you may consider whether a traditional individual retirement account or Roth IRA is more advantageous for your circumstances. If you decide to convert your funds from a traditional to a Roth IRA, there are tax consequences to consider, both positive and negative. Consult with an attorney or financial professional with specific questions concerning your retirement plans.
Taxes on Converted Funds
Funds that you contribute to a traditional IRA are tax-deferred, meaning you do not pay federal income tax on the money until you begin making withdrawals from the IRA. This lowers your tax obligation at the time you make the contribution and may result in tax savings when you begin withdrawing the money, assuming you are in a lower tax bracket once you retire. When you convert funds from a traditional to a Roth IRA, you must pay federal income taxes on the funds you convert. This is because Roth IRAs are considered post-tax retirement funds. If you do not have funds available to cover this tax obligation, you will need to make the payment from the IRA, lowering the overall value of the transferred Roth IRA.
Tax Liability for Withdrawals
Once you begin withdrawing funds from a traditional IRA, you must pay income taxes on the money you receive, at the tax rate effective at the time you receive the funds. In many cases, this tax rate is lower than the tax rate that would have applied when the funds were added to the traditional IRA. However, once you convert your traditional IRA to a Roth IRA, you can withdraw funds freely with no tax liability once you reach age 59 1/2. Therefore, if you expect to be in a higher tax bracket after retirement than your present tax bracket, converting to a Roth IRA can financially beneficial.
The Five-Year Rule
An important factor to consider when making a decision on whether to convert your traditional IRA to a Roth IRA is the five-year rule imposed by the Internal Revenue Service. The five-year rule requires that you leave funds deposited in a Roth IRA for at least five years before making the first withdrawal. If you make a withdrawal of earnings -- that is, the interest applied to your contributions -- from a Roth IRA within five years of depositing those funds, you are liable for a 10 percent tax penalty from the IRS.
Timing Your Conversion
At one time, the IRS limited conversions from traditional to Roth IRAs to households with incomes less than $100,000. However, the Tax Increase Prevention and Reconciliation Act eliminated this limitation as of 2010. However, to gain the most tax-free benefit from converting to a Roth IRA, transfer your funds early in the year. On the other hand, if you're unsure of what your income circumstance will be for the year, waiting until the second half of the year may make sense, according to financial website Bankrate.com.
- "Forbes;" Five Reasons Not To Convert To A Roth IRA; Robert Keebler; Marcn 2010
- "Forbes": In Pictures --10 Reasons To Convert To A Roth IRA
- Internal Revenue Service: Publication 590 -- Traditional IRA
- Internal Revenue Service: Publication 590 -- Roth IRA
- Franklin Templeton Investments: Converting to a Roth IRA?
- MSN Money; Best Time to Convert to a Roth IRA?; Robert Powell; August 2009
- Bankrate; Converting a Traditional IRA to a Roth IRA; George Saenz; Nobember 2010
- CBS Money Watch; Roth IRA: Should You Convert? Here's How to Tell; Janet Kidd Stewart; January 2010
- Bankrate; Seven Steps to a Roth IRA Conversion; Amy Buttell; March 2010
- Tax Guide for Investors; Advantages of Conversion; Kaye Thomas; January 2007
About the Author
Chris Blank is an independent writer and research consultant with more than 20 years' experience. Blank specializes in social policy analysis, current events, popular culture and travel. His work has appeared both online and in print publications. He holds a Master of Arts in sociology and a Juris Doctor.
- Comstock/Comstock/Getty Images