Roth IRAs are a great way to save on your taxes, because the income and gains within a Roth IRA are generally not subject to tax even when you make withdrawals from your account in retirement. Yet if you're looking at doing rollovers in order to get money into a Roth IRA, then it's important to understand the tax consequences that can result. In particular, although some types of Roth IRA rollovers are tax-free, other transfers of money into a Roth IRA can require you to pay tax.
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Financial professionals use the term "rollover" to refer to a number of different types of transactions related to retirement accounts. The reason that creates confusion here is that only some of those transactions require you to pay taxes. So just because you're doing a rollover doesn't necessarily mean that you'll owe tax.
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For instance, if you're doing a rollover from an existing Roth IRA to another Roth IRA, then no tax will be due. As long as you meet the requirements for a rollover -- getting the money redeposited in the new Roth IRA within a 60-day period -- then you'll be fine. In addition, direct trustee-to-trustee transfers of Roth IRA assets from one financial institution to another will also result in no tax impact.
However, if you want to convert a traditional IRA to a Roth IRA, then there are tax consequences. The IRS specifically lists a rollover from a traditional IRA to a Roth as one way of completing a Roth conversion. In addition, direct transfers from the financial institution managing the traditional IRA to the institution that will manage the Roth IRA also qualify for conversion treatment.
Similarly, if you have a 401(k) plan or other employer-sponsored retirement account, you can directly roll that money over to a Roth IRA under certain circumstances. That will be treated as a Roth conversion, with the attendant tax consequences.
How Roth conversions get taxed
If you are taking money from a traditional-style IRA or 401(k) and rolling it over into a Roth IRA, then the typical tax treatment requires you to include the amount that you converted as taxable income in the year of the conversion. That's the case even if you meet all the deadlines for getting the money into the Roth IRA in a timely manner within the 60-day window.
One key exception involves those who have after-tax money in their traditional IRAs. If you made nondeductible contributions to your traditional IRA at some point in the past, then you won't have to pay tax on those contribution amounts. However, any income or gains on that money will be included as taxable income. So, for instance, if you made a $2,000 nondeductible contribution to an IRA and it has since grown to $3,000, you'll have to pay tax on the $1,000 growth in the IRA if you roll it over to a Roth, but you won't have to pay tax on the original $2,000 contribution amount.
What to watch out for
Finally, one thing you'll need to watch carefully is whether the institution holding the IRA or 401(k) that you're rolling over withholds any tax from the amount they transfer. With most direct transfers, financial institutions won't do withholding unless you explicitly tell them to do so. However, if you take position of the money yourself through a rollover, then some institutions will automatically withhold for taxes unless you tell them not to withhold anything. If money does get withheld, then if you don't make up for it when you complete the rollover, you'll typically owe an additional 10% penalty if you haven't yet reached age 59 1/2.
Rolling over money into a Roth IRA can be a smart tax-planning move, but you have to understand the tax consequences going into the transaction. By focusing on the initial source of the funds, you can figure out whether or not you'll owe tax on the rollover and plan accordingly.
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