Depending on your income, you might be able to fund your rollover IRA to Roth IRA. Congress felt that the Roth IRA was too good of a deal to extend to higher-income taxpayers, so they placed lower caps on it. The online IRA calculator available here to compare the ordinary taxable rollover IRA to Roth IRA investment plans. Also compare Roth vs. Traditional IRA rollover to determine which IRA may be right for you.
The difference between your rollover IRA or Roth IRA is that instead of a tax deduction for your contribution, you get tax-free distributions later. It’s important to understand that if your tax rate stays the same, it doesn’t make a penny’s difference to your retirement income picture whether you use a traditional or Roth IRA rollover. Your net or after-tax income on withdrawals will be the same in either case.
If your tax rate goes up when you distribute your IRA rollover account later after retirement, you will be happy. Many believe that the current low tax rate is not sustainable—at least you wouldn’t want to be the farm that it is. Having an IRA rollover account for at least part of your retirement investments plan, hedges against possible tax increases later.
Another great use for a Roth IRA rollover is for young people who haven’t reached their full income potential. At low income tax rates, the value of the tax deduction given up by using a Roth IRA is negligible. Later, when they withdraw the funds tax-free that would have otherwise been taxed at a high rate, they will receive substantial tax benefits. In essence, they would have leveraged the tax code by the amount of the difference in their contribution and withdrawal tax rates. That’s very powerful. For instance, if you are in a 15% tax bracket now, the value of a $1,000 tax deduction is only $150. Let’s say that over time, your Roth IRA grows to $5,000. If you forgo the tax deduction and opt for the Roth IRA, when you take it out after retirement, you keep the entire $5,000 no matter how high your current tax bracket. If you had taken advantage of the Regular rollover IRA’s tax benefits, you would have saved $150, but you would be faced with tax on the entire $5,000 when you withdraw it. So the amount in your hands after tax would be far less.
Roth IRAs offer some benefits for your estate. In essence, you have prepaid the income tax on the entire amount for your heirs. The ability to stretch the tax-free distributions across at least two generations is very powerful. Additionally, there are no forced withdrawals at age 59.5. These advantages may or may not be an important issue for you, but it’s an added benefits.
Contributions of Rollover IRA to a Roth IRA can always be withdrawn tax free. But, the earnings must remain in the account until the account holder reaches age 59.5, or five years after deposit—whichever is later—to receive tax-free treatment.
The ability to withdraw contributions tax-free makes them a great way to accomplish multiple goals in a tax-preferred manner. Suppose, for example, after a number of years of contributions, you withdrew those contributions to fund your daughter’s college education while leaving the earnings to compound tax-free for your later retirement.