If you have an individual retirement account, either through an employer sponsored 401k plan, or through a traditional IRA, you may be wondering if you can convert these funds to a tax-advantaged Roth IRA. A Roth IRA allows you to pay ordinary personal income tax on contributions, and withdrawal funds tax-free upon retirement.
For many people, converting to a Roth IRA is a wise decision, as many people move into a higher tax-bracket when they reach retirement, making the tax savings in a Roth IRA particularly advantageous. There are some IRS Roth conversion rules that should be taken into consideration before rolling over your retirement accounts to a Roth IRA.
IRS Roth Conversion Rules
As of 2010, the IRS Roth conversion rules have changed. Prior to 2010, investors could only convert to a Roth IRA if they had a modified adjusted gross income of less than $100,000. Changes to the laws made in 2010 lifted the income limits, making Roth IRAs available to most investors.
The limits placed on Roth IRA conversions vary from state to state, and you should always seek the advice of a qualified investment adviser. Many online brokerages such as ETrade even offer rollover specialists, who can assist you in determining if you are eligible to convert to a Roth IRA.
If your employer sponsored retirement plan restricts you from making Roth-designated contributions to your 401k – not every employer plan allows this – another avenue you can take in order to realize the tax benefits of a Roth account is to roll over all or some of the funds in your traditional IRA to a Roth IRA.
When Does It Make Sense To Convert To A Roth IRA?
Although you will be required to pay the current year’s income tax on funds rolled over into a Roth IRA, a Roth account might still make sense for you if you believe that your taxes may be the same or higher when you withdraw funds.
It may also make sense for you if you are young and have a long time-frame for investing. As your funds grow and compound over time, you can rest easy at night knowing that your gains are tax-free. If you are older, a Roth IRA would make sense if you plan to will the fund as a tax-free inheritance for your heirs or charity and do not plan on needing the money.
IRS Roth Conversion Rules: Conversion Tax
When converting your retirement funds to a Roth IRA it is important to note that you should have the cash on hand to pay the required conversion tax. You lose the potential benefit of tax-free gains on your funds if you pay the conversion tax from your IRA.
Withdrawing money in order to pay the conversion tax is an even worse idea if you are under 59½ , as you would incur an additional 10% federal penalty, as well as possible state penalties. If you would need to sell appreciated assets to pay the tax, you would also have the capital gains tax working against you.
It is always important to speak with a professional financial adviser to discuss the specific aspects of your unique situation. Whether it is the trained financial professionals at ETrade, or the investment adviser at your bank or credit union, only you and your broker can determine if Roth IRAs are right for you.