Lured by the idea of tax-free earnings, 16 million people have
purchased Roth IRAs since they were introduced in 1998
– and one-third of those individuals say they funded their
purchase by converting from a traditional IRA according to the
Investment Company Institute, 2003. If tax- exempt earnings sound
appealing to you, you may want to consider a Roth IRA conversion.
But before you make the change, there are
several things you should know.
Lured by the idea of tax-free earnings, 16 million people have purchased Roth IRAs since they were introduced in 1998 – and one-third of those individuals say they funded their purchase by converting from a traditional IRA according to the Investment Company Institute, 2003. If tax- exempt earnings sound appealing to you, you may want to consider a Roth IRA conversion. But before you make the change, there are several things you should know.
Roth IRA contributions are made with after-tax dollars, but earnings accumulate tax deferred. Qualified withdrawals (usually during retirement) are free of federal tax.
To qualify for the tax-free and penalty-free withdrawal of earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after age 59 ½ or due to death, disability or a first-time home purchase (up to a $10,000 lifetime maximum). Depending on state law, Roth IRA distributions may be subject to state taxes.
Contributions to traditional IRAs may be tax deductible, and earnings accumulate tax deferred. Federal income taxes are due only upon withdrawal (again, usually in retirement).
No more than $3,000 ($3,500 for those age 50 and older) may be contributed to Roth and traditional IRAs combined in 2004. And Roth IRA contributions may be limited further for workers whose modified adjusted gross income exceeds $95,000 for single filers, or $150,000 for married couples filing jointly.
Converting funds from a traditional IRA to a Roth IRA requires that you pay taxes on the amount converted immediately. So if you expect to be in a higher tax bracket when you retire, a Roth IRA conversion may be appropriate now (assuming the conversion keeps you in a favorable tax bracket in the year you convert.)
Unlike traditional IRAs, Roth IRAs are not subject to mandatory withdrawals at age 70 ½, meaning you can continue the tax-deferred status of your savings indefinitely.
When you convert a traditional IRA to a Roth IRA, you must pay ordinary income taxes on any deductible contributions and earnings within the IRA. However, if you withdraw funds from inside the account to pay those taxes before age 59 1/2, the money will also be subject to an additional 10% federal tax penalty on top of taxes. It is usually a good idea to set aside money from outside the IRA to cover taxes at the time of conversion.
Both types of IRAs offer distinct advantages to investors. Whether you should make the switch to a Roth IRA ultimately depends on which set of benefits best suits you specific situation. For more information about the advantages and drawbacks of Roth IRA conversions, contact your tax professional or investment advisor.
Dan Newquist is a registered representative with Linsco/Private Ledger (member SIPC). His office is in Morgan Hill.
