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Roth Ira Rollover - What You Need to Know Before Doing a Roth IRA Rollover

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When considering a Roth IRA rollover, you need to consider the differences between a traditional IRA and a Roth IRA as well as the tax consequences that will result from converting your traditional IRA to a Roth. While the positive tax benefits of a Roth IRA won’t be felt for many years, the conversion could have a negative effect on your taxes for the next year or two because you will have to pay taxes on the amount that is rolled over.

The reason for the taxation on Roth IRA rollovers is that the money you put into your traditional IRA was not taxed. In a traditional IRA, the money is taxed when you take it out, not when you put it in. With a Roth IRA, the reverse is true. Contributions to a Roth IRA are not tax-deductible; you pay income taxes on the money you deposit into your Roth IRA account in the year in which it was earned. With a Roth IRA, any money you take out of the account after retirement age is tax-free. That means you never have to pay taxes on the increase in value of your investments over the years.

Although Roth IRAs are often recommended over traditional IRAs because of the potential tax savings at the time of withdrawal, doing a Roth IRA rollover is far from a no-brainer. Since no taxes have been paid on the money that is in your traditional IRA, when you roll the money over to a Roth IRA, the money you convert is counted as income in the year that the IRA is converted, which could significantly increase the amount of income taxes due that year, depending on how much money you have in your IRA.

If you do your Roth IRA rollover in the year 2010, there is a special tax break that allows you to pay the additional income taxes on your 2011 and 2012 tax returns instead of paying all of the tax when you file your 2010 return. This is an incentive for people to convert now, but remember that delaying the tax bill does not make it go away. If you fail to plan properly so that you will be able to cover the additional taxes, you could find yourself in trouble with the IRS, and that is not a good place to be.

If you have the money to pay the extra income taxes that will be incurred as a result of the rollover, you need to determine whether switching to a Roth IRA is likely to benefit you at the time of retirement. The answer to that question depends on how much money you have in your IRA, how long you have until retirement and how aggressive your investment strategy is.

For people with many years until retirement who invest in potentially high-yield investments such as growth funds, switching to a Roth IRA probably makes sense, especially if you already have a good-sized nest egg growing. For those with small accounts who don’t expect to have much even by the time retirement rolls around, switching to a Roth IRA makes a lot less sense.

The reason for this is that withdrawals from a traditional IRA are taxed as income at the time they are withdrawn. If you have a small retirement fund and are only withdrawing $2,000 per month, that means you are going to be taxed as if you made $24,000 in income for the year. As long as you don’t have income from other sources, you will be in a lower tax bracket so your tax liability for the year should not be too high. In this case, you won’t save a lot by switching to a Roth IRA because you aren’t paying that many taxes at retirement time anyhow.

If, however, you have a large amount of money in your traditional IRA when you retire, the income taxes you incur will be higher because you will likely be withdrawing a lot more money each year. In this case, you would probably save quite a bit of money by not having to pay taxes on your withdrawals, so a Roth IRA makes more sense. You’ll need to do the math yourself to determine which investment vehicle makes more sense for you.

Roth Ira Tax - Roth IRA Tax Implications [next] [back] Roth Ira Maximum - What Is The Advantage To The Roth Ira Maximum Contribution?

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