If you have a traditional IRA or employer-sponsored retirement plan, you have the option of converting those retirement accounts to a Roth IRA. In fact, making the conversion is very easy, especially if you understand how to convert to a Roth IRA. You can choose to transfer some or all of your existing retirement account balance to your new Roth IRA, regardless of income.
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?
Converting to a Roth IRA is most beneficial when your income is too high for you to contribute to a Roth IRA that year, but you anticipate that your tax rate will be higher when you retire. Another consideration is whether the amount you expect to convert, along with your current year’s income, will not result in a substantial tax burden. If the conversion will result in pushing you into a higher tax bracket or subjecting you to taxes you would not otherwise be required to pay, then it may not
How to make the conversion
The simplest way is to make a direct trustee-to-trustee transfer, from one financial institution to another. Or, if you intend to keep the retirement account at the same investment firm, you can easily request that your traditional IRA be re-designated as a Roth IRA, instead of opening a new account.
The same is true for converting 401(k) or an employer-sponsored plan to a Roth IRA. Make sure that the funds are transferred directly from one financial institution to the next. If you are issued a check, you are required to withhold 20% of the amount for tax purposes. As long as you deposit all of the money, including the 20%, into a new Roth account within 60 days, you will not suffer a penalty. If you miss the deadline, then any money not rolled over into the Roth IRA will be subject to a 10% early withdrawal penalty. This penalty is imposed if you are younger than 59 ½, in addition to the income taxes you owe on the entire converted balance.
How is a Roth IRA different?
IRAs come with eligibility requirements with regard to income. A Traditional IRA allows anyone who has earned income, younger than 70 ½-years-old, to make contributions. A Roth IRA only allows contributions if the individual’s income falls within certain limitations. In 2015, the income limit is $116,000 for an individual. Earned income is the money you are paid to work, including wages, salaries, tips, bonuses, commissions, and self-employment income.
Differences in Tax Incentives
Traditional IRA contributions are tax deductible on both state and federal tax returns, during the year you make the contribution. However, withdrawals during retirement are taxed at the ordinary income tax rates. Roth IRAs do not provide a tax break for contributions. Instead, the earnings and withdrawals are generally tax-free. Put another way, you can avoid taxes when you put money in a traditional IRA, while you avoid taxes when you take money out of a Roth IRA during retirement.
If you have questions regarding Roth IRAs, or any other retirement planning needs, please contact the Schomer Law Group either online or by calling us at (310) 337-7696.