Rollover Retirement Fund to Conventional IRA Vs. Roth IRA
When it comes to deciding the destination for your 401k rollover, it may feel like one IRA is just as good as another. Choosing a Roth over a traditional IRA--or vice versa--has both long- and short-term tax consequences. It is important to understand the benefits and drawbacks of each before making your decision.
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Traditional IRA: Benefits
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Traditional IRAs are tax deferred accounts and are the most like your current 401k. You can roll over your 401k account into a traditional IRA with no tax consequences. Your contributions will continue to grow tax deferred and you can make additional tax deductible contributions over time. You will pay tax only when you take distributions in retirement.
Roth IRA: Benefits
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Roth IRAs are future tax-exempt accounts, provided you follow the Internal Revenue Service guidelines for withdrawals. You may deposit contributions into a Roth IRA account throughout your life and you will be permitted to withdraw contributions, conversions and earnings tax free, as will your beneficiaries after your death. You are never required to take a distribution on a Roth IRA account.
If you have funds in a Roth 401k, this is your only rollover option for that portion of your account. Roth 401k assets cannot be rolled into a traditional account.
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Traditional IRA: Drawbacks
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With a traditional IRA, you will be taxed on your distributions and you will be required to take distributions. You will have a required minimum distribution beginning at age 70 1/2. Distributions to your beneficiaries after your death will also be taxed.
Roth IRA: Drawbacks
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Money in Roth IRAs has to be taxed prior to deposit. This means that you will owe ordinary income tax on the value of your account in the year you perform the rollover. You will be required to hold the rollover deposit in the account for a period of five years prior to taking a distribution if you want to avoid tax penalties. In addition, you may be prohibited from making additional contributions if your income is over the IRS limit ($120,000 for single taxpayers in 2010).
Considerations
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If your income is over the IRS limit for Roth contributions, a 401k rollover offers a good opportunity to take a substantial advantage of the tax benefits a Roth can offer. It is important to note that you neither have to convert all traditional assets at once nor do you need to roll over all 401k assets to a single account. You can split the 401k into both Roth and traditional accounts and pay tax only on the Roth portion at the time of conversion. You may then convert additional traditional IRA assets a later date and spread out the tax consequences of the conversion.
It is also important to consider your current and expected tax situation. If your tax obligation is currently high, a traditional IRA will avoid any additional taxes. This is especially helpful if you believe you will be in a lower tax bracket in retirement. However, if you are currently in a lower tax bracket and expect to move up, the Roth IRA may be a better choice. For some, splitting their assets between both types of accounts may feel like a better choice as they plan for the future.
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