Converting to a Roth IRA is the process of transferring pre-tax or after-tax contributions from a traditional individual retirement account (IRA) to a Roth IRA. This can be beneficial because Roth accounts offer some unique features as a means of retirement savings. For example, you are not required to take required minimum distributions (RMDs) from Roth IRA accounts. Also, your money can grow tax-free, subject to certain rules that are not entirely restrictive.
Unlimited Roth IRA Conversions
Roth IRA conversions are unlimited in terms of the amount you can convert to a Roth account or your income, but they may affect the tax-free treatment of withdrawals in retirement.
The Five-Year Rule for Withdrawals from a Roth IRA
Roth IRAs are subject to a five-year rule. You cannot withdraw money from a Roth account before five years have passed since the account was opened or before you reach age 59 and a half, whichever occurs later. A penalty tax of 10% will be imposed if you do so.
Roth Conversions Cannot Be Undone
When you “redirect” your contributions to an IRA, you treat the direct contributions to that account as though they were made to the other account, whether it is a traditional or Roth account. You can move money from one account to another before the tax return filing deadline and treat that contribution as if it was made during the tax year. The contribution made to the first account is cleared and canceled.
Taxes on Roth IRA Conversions
That does not mean the IRS won’t require you to pay some taxes if you convert to a Roth IRA.
Contributions to traditional retirement accounts are usually made with dollars that have not been taxed. You can claim a tax deduction for them in the year that you make the contribution, subject to certain income limits. These funds are taxed later when you withdraw them in retirement.
However, Roth IRA distributions are tax-free, according to the five-year rule and the age 59 and a half rule. Therefore, the amount you convert to a Roth account is taxed as income in the year you make the conversion.
Frequently Asked Questions (FAQs)
When are taxes paid on a Roth IRA conversion?
The converted funds are treated as taxable income in the year that the funds are withdrawn from the traditional retirement account if you claimed a tax deduction for the contributions at the time you made them.
When is the best time to start a Roth IRA conversion?
One of the biggest advantages of a Roth IRA is that the funds contributed or converted to the account grow tax-free, unlike a traditional retirement account where both original contributions and earnings are fully taxable upon withdrawal. You will enjoy more tax-free savings if you convert early, well in advance of retirement, allowing the funds more time to grow.
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Sources:
- Wells Fargo. “Converting to a Roth IRA.”
- Congressional Research Service. “Rollovers and Conversions to Roth IRAs and Designated Roth Accounts: Proposed Changes in Budget Reconciliation,” Page 1.
- IRS.
- IRS. “Amount of Roth IRA Contributions That You Can Make for 2022.”
- IRS. “Rollovers of Retirement Plan and IRA Distributions.”
- IRS. “IRA FAQs.”
- BECU Investment Services. “What To Know About Roth IRA Conversions.”
Source: https://www.thebalancemoney.com/what-are-roth-ira-conversion-limits-5270894
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