Planning for Retirement – Traditional IRA vs. Roth IRA

There are many vehicles used for retirement planning. One of the most common is the traditional IRA (individual retirement account). Contributions to IRAs are often tax deductible and distributions are often taxable as income. Another type of IRA is the Roth IRA in which contributions are made after tax and distributions can be tax-free. Tax-free withdrawals can be attractive which often prompts the question - can a traditional IRA be converted to a Roth IRA?

The answer is yes, provided you meet the eligibility requirements below and understand how it works.

The IRA owner must not exceed adjusted gross income of $100,000 in the year of the conversion – and that applies to both single taxpayers and married taxpayers filing jointly. For 2008 and 2009, the $100,000 income limit will still apply.

The conversion will be treated as a distribution from the Traditional IRA. Therefore, any deductible contributions and gain will be taxable to the owner and included in income in the year of the conversion.

The distribution is not subject to the 10% federal income tax penalty. And, for purposes of determining conversion eligibility, the conversion amount is not added to the individual’s adjusted gross income. Beginning in 2010, there will no longer be an adjusted gross income limit for Roth Conversions.

It is important to note that currently funds from an employer-sponsored retirement plan cannot be rolled directly into a Roth IRA. The money must first be rolled into a Traditional IRA and then may be converted to a Roth IRA. Beginning in 2008, employer-sponsored retirement plans will be able to be rolled directly to a Roth IRA.

For Roth owners under age 59 ½, a special rule applies to conversion amounts. Withdrawals from a Roth IRA, both basic and earned dollars, made in the five-year period will be taxable and subject to the conversion portion of the 10% penalty. This prevents a Traditional IRA owner from avoiding the 10% penalty by first converting to a Roth IRA.

IRA transfers and rollovers are powerful financial tools. If properly handled, these transactions allow funds to be shifted between IRAs or withdrawn without paying income taxes. The end result is often greater convenience and/or greater control of funds for the IRA owner. If you think a transfer or rollover might make sense for you or you just have questions, please feel welcome to contact me.