Roth conversion

What is a Roth conversion?

A Roth conversion is the moving of assets from a tax-deductible traditional individual retirement account, or IRA, to a non-deductible Roth IRA. Participants in Roth IRAs don’t pay income tax when they withdraw those funds in retirement because money deposited into a Roth is from after-tax income.

Deeper definition

The most important distinction between a traditional IRA and a Roth IRA is that traditional IRAs are grown with pretax income and taxed when the funds are withdrawn, while Roth IRAs are contributed to with after-tax income and are tax-free at withdrawal. That makes Roth IRAs a better option for people who think they’ll be in a higher tax bracket when they’re older.

However, because Roth IRAs limit contributions from people who earn a higher income, many high earners put their money in traditional IRAs, which don’t have income limits. If these wealthy people want to invest in a Roth IRA, they’ll have to convert their traditional IRAs in a Roth conversion. Roth conversions themselves used to have income limits, but these have since been removed.

Another term for a Roth conversion is a “backdoor” Roth IRA contribution. The conversion is carried out through an asset rollover between the trustees of the traditional IRA and the Roth IRA. Because contributions to a Roth IRA are made after tax, it follows that converting a traditional IRA to a Roth IRA would incur a tax penalty. In fact, the account holder will pay taxes on the entire amount she converts unless the funds from the traditional IRA were not tax-deductible, in which case she has already paid taxes on them.

Roth conversions require the customer to wait five years before withdrawing the money to avoid a tax penalty, and with a Roth IRA earnings can’t be withdrawn without a tax penalty at all until the account holder turns 59 ½. It’s also possible to undo a Roth conversion and recoup the tax dollars spent, but only within a specified time frame.

Can’t wait to get a return on your investment? Try a money market account instead.

Roth conversion example

A tax-savvy investor with a large simple IRA account wants to see his money grow tax-free. He consults his financial planner and decides to convert his conventional IRA into a Roth IRA. The conversion, however, doesn’t get him out of paying taxes. The traditional IRA is from pre-tax income, so he will owe federal income tax on that money. After the Roth conversion, though, his money grows tax-free and he can withdraw it without paying more taxes when he retires.

 

Other IRA Terms

Annuitizing an IRA

Annuitizing an IRA can give you early access to IRA funds. Bankrate explains.

Deductible contribution

What does deductible contribution mean? Let Bankrate explain.

Required minimum distribution

You need to understand what required minimum distribution is. Here’s what to know.

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