Paying the Roth Conversion Tax
Because of the tax benefits of a Roth IRA, many investors have decided to convert their traditional IRA to a Roth. With a Roth IRA, contributions are made from post tax income, which means that you may qualify for tax free distributions if you meet the requirements established by the IRS. By comparison, contributions to a traditional IRA are made before taxes, so taxes must be paid on these funds when you collect distributions. When you convert a traditional IRA to a Roth account, you must pay tax on the converted amount.
Converting from a Traditional IRA
Converting from a traditional IRA to a Roth IRA has a number of advantages. If you have held the account for at least 5 years, you may make tax free withdrawals from a Roth IRA once you reach the age of 59 1/2. You may also be eligible for an early qualified distribution without tax penalties if you are buying or building a first home, have large unreimbursed medical bills or become physically disabled.
For investors whose income exceeds the IRS cap, a Roth conversion has specific benefits. Investors with a high income may convert funds from a traditional IRA to a Roth IRA and avoid the maximum income restriction. If you have been restricted from opening a Roth IRA because of your earnings, a conversion may allow you to avoid this limitation.
During the year that you convert a traditional IRA to a Roth IRA, you must pay taxes on the distribution from the Roth IRA. Because taxes are not paid on contributions to a traditional account, income tax is due on these funds when you withdraw the money. The distributions from your IRA will be taxed as income in that year, and you must pay the conversion tax when your annual income taxes are due.
The amount of income tax that you must pay for your IRA distribution will depend on your income bracket. If the amount you are distributing is large enough, it may put you into a higher tax bracket for that year. Work with your investment advisor or a tax professional to plan your conversion so that you minimize the amount of income tax you owe. If you anticipate earning less than your usual income this year, it could be a good time to consider converting your traditional IRA to a Roth IRA.
Once you've converted your traditional IRA to a Roth IRA, the contributions that you make to the retirement account will be deducted from your post tax income. Contributions to a Roth IRA are not tax deductible, which means that your annual tax obligation will be higher if you stop making contributions to a traditional IRA. However, you can enjoy tax free deductions when it's time to collect your distributions.
Special Exception for 2010
In 2010, investors were allowed to distribute the income tax for a Roth IRA conversion over two years. However, this rule was an exception that no longer applies. After 2010, you must pay the income tax for a Roth IRA conversion during the same year that you take the distribution. [1]
Paying the Roth conversion tax is a factor that all investors must consider when they make this decision. The larger your distribution, the more tax you must pay when you have these funds converted. However, the funds that you have converted will continue to earn tax free interest and dividends for the rest of your life. To make the most of this opportunity while minimizing your tax obligations, work with a tax professional or investment advisor.
http://www.irs.gov/publications/p590/ 01/23/2012
Did you Know?
The Roth IRA is a retirement account that is funded with post-tax income. You pay taxes on your income this year as you would during any year and invest the funds in the Roth. Since taxes have been paid before investing you never pay income taxes on those funds in the future.
