Do Roth Conversions Incur Penalties?
There are significant differences between a traditional IRA and a Roth IRA. For taxpayers who decide the advantages of a Roth IRA outweigh the advantages of a traditional IRA, there is a way to convert from a traditional IRA account to a Roth IRA. Understanding the tax consequences of a Roth conversion is the first step in determining if such a move makes sense financially.
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History
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Before 2010, only taxpayers with incomes below $100,000 were permitted to do Roth IRA conversions. However, in 2010, the rules were changed so that all taxpayers, regardless of income, may take advantage of Roth conversions.
Benefits
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Funds invested in a Roth IRA grow tax deferred. In addition, if the account owner is 59 1/2 or older, all withdrawals from the account are tax-free. Finally, Roth IRAs are not subject to required minimum distributions, or RMDs, as traditional IRA accounts are.
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Considerations
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Contributions to a Roth IRA must always be made with after-tax dollars. Qualified retirement plans such as 401(k)s and traditional IRAs may be funded with pre-tax dollars. In order to convert from one of these retirement plans to a Roth, taxes must be paid on the amount converted. The exception is that no taxes are due on any after-tax contributions made to the original retirement plan.
Misconceptions
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While taxes must be paid on monies converted to Roth IRAs, only ordinary income taxes are due. There are no additional taxes or penalties due on any converted funds.
Warning
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The money converted to a Roth IRA counts as ordinary income for tax purposes. For large conversions, this amount can put the taxpayer in a higher tax bracket, or raise his adjusted gross income above the allowable limits for certain tax deductions or tax credits. Consult a tax professional for advice.
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