Ira Conversion

Today we will discuss IRA Conversion. That is when the owner of a Traditional IRA does a rollover of their account into a Roth IRA. Since the tax consequences of a Traditional and Roth IRA are not the same, the event is considered a conversion instead of a rollover. This is because the taxable income of the Traditional is being converted to the nontaxable income of the Roth.

Individual Retirement Accounts (IRAs) were set up as a personal retirement plan. Traditional IRAs are funded by before tax contributions. They were designed so taxes are not paid until the funds are withdrawn after retirement when the owner's tax rate is usually lower.

Per IRS regulations, the funds of a Traditional IRA cannot be withdrawn before age 59-1/2. If the owner does make a withdrawal before they turn 59-1/2, they incur a 10% penalty for violating the IRS regulations. They are also required to pay taxes on the additional income.

The exemptions from the penalty are disability, first time home purchase, education expenses, payment of health insurance premiums for the unemployed, or an IRS tax levy.

Roth IRAs are funded by after tax contributions. The funds should not be withdrawn until after they have been in the account for a minimum of 5 years.

When Roth IRA funds are withdrawn after the 5 year time frame, these funds are a nontaxable event as the taxes were paid at the time they were earned. If the funds are withdrawn before the 5 year time frame there is no set penalty. However, taxes will have to be paid in exchange for not following the IRS regulations.

After checking with their Financial Planner, some people prefer to choose a financially convenient time to move part or all of their Traditional IRA into a Roth paying taxes on the amount moved at the time of the conversion. This means that once they retire and have less income, they will be allowed to make tax free withdrawals.