Many investors start saving for retirement by opening a traditional individual retirement account, or IRA. Younger investors especially are interested in the tax deduction offered by regular IRA contributions. Older investors perhaps opened their traditional IRAs before there was a choice — the newer Roth IRAs were not available until passage of the Taxpayer Relief Act of 1997. However, soon after inauguration of the Roth IRA, the Internal Revenue Service offered investors in traditional IRAs the option of rolling their investment over into a Roth IRA.
The primary reason to execute an IRA rollover is the tax benefit offered by a Roth IRA — all withdrawals are tax free. Withdrawals from a regular IRA, on the other hand, are subject to tax as ordinary income. However, when you do your conversion, you’ll owe tax on the amount converted — both on deductible contributions to your traditional IRA and on earnings up until the moment of conversion. (Nondeductible contributions to a regular IRA are not taxable and can be deducted from the taxable amount.) For many, this tax burden is substantial; some choose to convert their traditional IRAs to a Roth over several years, spreading out the tax burden. There are many other considerations — your current tax bracket and anticipated tax bracket in retirement, for instance — so you’ll need to do the math. For most investors, however, conversion to a Roth is ultimately the better strategy.
How do you do an IRA rollover?
The financial institution that holds your IRA can help you with the paperwork. Assuming you’ll be keeping your new Roth IRA with the same institution, you can keep your assets invested in the same fund, basket of funds, or other investment products; it’s the nature of the account you’re changing, not the investments themselves. If you’re only doing a partial conversion and your traditional IRA account holds three different mutual funds, you’ll need to determine how to allocate these funds toward your initial (and subsequent) conversions, although each fund of course will return the same performance whether it’s invested in a traditional or a Roth IRA. If any of your contributions were nondeductible, be sure to confirm this with the investment house, to ensure that these amounts are not taxed. Your investment house will be submitting records of the conversion to the IRS, providing you with documents showing you how to record the transaction in your next tax filing.
In some cases, you may complete an IRA rollover but then change your mind. For instance, your IRA may have dropped considerably in value since you made the conversion, but you find that you still owe substantial tax on the transaction. The IRS allows you to “recharacterize” your rollover, basically pretending that it never happened. There’s a time limit — you have until October 15 of the year following the year in which the rollover happened. Depending on the timing and circumstances, it’s also possible to file an amended tax return nullifying the original rollover. Again, your financial institution can help you with paperwork, details, and tax forms. The number crunching can be daunting; don’t hesitate to enlist the help of a financial planner if you need help.
For most savers, rolling over your traditional IRA into a Roth makes sense in the long term. Calculate how much you’ll spend now in taxes versus how much you stand to pay later in taxes, and take it from there.
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