Author: T. Eric Reich, CIMA®, CFP®, CLU®, ChFC®
Source
If you’re like a lot of people, you’re familiar with traditional IRAs and Roth IRAs, but not entirely sure how they are the same, and more importantly how they are different. So, here is a quick recap on Roth vs. traditional IRAs.
A traditional IRA can allow for a tax deduction and tax-deferred growth until you take the money out. At that time, any withdrawals are subject to ordinary income tax.
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By contrast, a Roth IRA does not allow for a tax deduction when the contribution is made. All of the funds also grow tax deferred, but qualified distributions are tax free. A qualified distribution is one that is not subject to tax or penalty. A distribution is considered qualified when it is from a Roth IRA that was established five years or more ago and it is made by someone who is over age 59½ (or meets the penalty exceptions such as death, disability or first home purchase). This is why a Roth IRA can be attractive for many investors. Future tax-free income is likely to be even more important down the road if tax rates increase, which it’s hard to imagine they won’t given our $30 trillion debt.
Even though most investors are familiar with Roth IRAs, the rules for their distributions can be complicated. Here are a few of the important rules to know regarding withdrawing Roth IRA contributions, making conversions and how the interest earned on them is treated.
1. Withdrawing Your Roth IRA Contributions
Anytime you take a distribution from a Roth IRA, the first money to come out is your contributions. You can take out all of your contributions without penalty or tax even if you aren’t 59½ and the Roth is less than five years old.
2. Roth IRA Conversions
Anyone can do a Roth IRA conversion regardless of their age or income. This confuses many people. Contributions can only be made by those who meet the income requirements and maximum contribution limits. Conversions from a traditional IRA to a Roth IRA can be done by anyone and in any amount without restriction.
When you convert from a traditional IRA to a Roth IRA, the amount that you convert is added to your gross income for that tax year. It increases your income, and you pay your ordinary tax rate on the conversion. The amount you convert could still be subject to the 10% early withdrawal penalty if you are under age 59½ or have had a Roth IRA for less than five years.
3. Tax Treatment of Earnings on Roth IRAs
If you have had a Roth IRA for at least five years and you are over age 59½, then even the earnings on your Roth IRA are tax free.
4. Required Minimum Distributions (RMDs)
A Roth IRA, unlike a traditional IRA, is not subject to RMDs. However, non-spouse beneficiaries are subject to RMDs if they inherit a Roth IRA. For most beneficiaries, those RMDs won’t likely need to be taken until the 10th year following the death of the Roth IRA owner. Inherited traditional IRAs require an RMD each year if the original owner was taking them, but Roth IRAs don’t until the end of the 10th year following death.
5. Converting an Inherited Traditional IRA
IRA beneficiaries cannot convert an inherited traditional IRA to a Roth IRA, but they can convert an inherited employer retirement plan.
Lastly, if you are converting a traditional IRA to a Roth IRA, it cannot be undone. Once a conversion happens, it is a permanent decision. You should discuss contributions, withdrawals and conversions with your CPA or adviser before proceeding in order to be aware of any potentially negative consequences.