First introduced in 1974, the Individual Retirement Account (IRA) has been a preferred way for U.S. citizens to save money for retirement.
Although the rules governing IRAs have changed over the years, the basic idea behind an IRA remains the same in, namely, to provide IRA holders tax advantages that encourage them to save for that point in life when they will no longer be working. Today, the two most popular IRA options are the Traditional IRA and the Roth IRA. This discussion covers all aspects of your IRA conversion rules for 2013.
The Traditional IRA provides tax benefits during the contribution period, as contributions are not subject to federal income tax as long as the contributor meets certain IRS requirements. Income tax is paid on any income the IRA provides via withdrawals during the account holder’s retirement years. Holders of a Roth IRA enjoy tax benefits when they withdraw their funds. As long as the IRS requirements are met, income from Roth IRA withdrawals is not subject to federal income tax. However, all contributions to a Roth IRA are made after tax.
Each IRA has its own advantages, but those who expect their federal tax rate to be higher in retirement than it is today are generally better off with a Roth IRA. Many people, however, have money tied up in a Traditional IRA or other retirement plan. Fortunately, these funds can be transferred into a Roth IRA.
Who Is Eligible to Convert a Tax-Deferred Retirement Account into a Roth IRA in 2013?
As of the year 2012, there are no income limits imposed by the IRS upon Roth IRA conversions. Anyone with a Traditional IRA, 401k, 403b or other similar retirement plan can convert it into a Roth IRA no matter how much they earn in a year. In past years, individuals making more than a defined income limit could not fully convert a Traditional IRA or other account into a Roth IRA. This limit has not applied since the 2010 tax year.
Are There Tax Implications for a Traditional IRA-Roth IRA Conversion?
Even though there are no income limits for a Roth IRA conversion, there are tax implications when a tax-deferred account is converted into Roth IRA. Since tax was never paid on contributions to a tax-deferred account, and since contributions to a Roth IRA are after-tax contributions, federal income tax must be paid on any funds involved in a Roth IRA conversion. These funds are taxed at the level of ordinary income. For example, individuals in the 15 percent tax bracket must pay $15,000 on federal income taxes if they convert a Traditional IRA worth $100,000 into a Roth IRA.
In 2010 and 2011, the tax could be split over two tax years when taxpayers made a Roth IRA conversion. As of 2012, that rule no longer applies. The income tax on the conversion must be paid in the tax year that the conversion occurred.
How Should Taxes Be Paid on a Roth IRA Conversion?
One thing that must be kept in mind about taxes on a Roth IRA conversion in 2013 is the source of the funds for the taxes that are owed. Many people will not have enough money in savings to cover the tax bill, and they will be tempted to use some of the conversion balance to meet their tax obligations. This is not a good idea, however, because it means that the account holder will sacrifice principal that can grow via compound earnings before withdrawals begin. Ultimately, the account holder’s total earnings will be reduced. In the long run, most people are better off keeping their Traditional IRA and not making a Roth IRA conversion if they do not have enough money saved elsewhere to cover any conversion-related tax obligations.
As this brief guide has indicated, there are definite advantages to converting a tax-deferred retirement account into a Roth IRA. Account holders should consult their financial adviser before making any final conversion decisions in order to make sure that they are doing the best thing possible with their retirement savings.