When it comes to Roth IRAs, the most important thing you must remember is that Roth IRAs are not structured like traditional IRAs. Traditional IRAs allow you to make contributions “off the top,” before any taxes are taken out of your gross salary. Contributions to Roth IRAs, conversely, are made with your after tax dollars, or net salary. This difference in the tax status of contributions is evident in almost every transaction involving a Roth IRA.
First, you cannot rollover funds from a Roth IRA into a traditionally structured IRA – you can only roll them over to another Roth IRA. If you think about it, this makes logical sense – one of the reasons to have a traditionally structured IRA is to defer taxes on that portion of your income, a benefit you’ve lost already if the money is in a Roth IRA. You can rollover funds from one Roth IRA to another Roth IRA if there is a compelling reason to do so, such as an opportunity to improve your investment portfolio’s management or returns.
You can also rollover funds from a traditionally structured IRA into a Roth IRA, but there will usually be taxes to be paid. Legislative changes for the 2010 tax year are making it more advantageous to have a Roth IRA conversion account. However, before you change the way your investments are structured, it’s a good idea to review your short and long term financial plans with a tax or financial adviser. It may be beneficial for some individuals to pay those taxes upfront and convert money into a Roth IRA, but not for all. Professional advice can help you to be certain where you stand before you initiate such a transaction.
One advantage of Roth IRAs is that having already paid taxes on the money you contributed, there are generally no taxes paid on withdrawals so long as they are considered qualified withdrawals or distributions. To be considered a qualified withdrawal, you must have been participating in the Roth IRA for a minimum of five years and you must be at least 59 ½ years old. However, if you’re buying your first home, become disabled, or are using your Roth IRA money to pay for higher education, then your distribution may be considered qualified without meeting those two criteria. Withdrawals or distributions that are deemed not qualified may be termed early withdrawals, upon which the IRS imposes a 10 percent tax penalty.
One rule you should be aware of is that if you attempt to rollover your funds to a Roth IRA and are unsuccessful for some reason, you may also be subject to early withdrawal penalties. Generally, speaking with the trustee or manager of the target Roth IRA will ensure that the Roth IRA is ready and able to accept any rollovers. In fact, not having an account which is ready and able to receive funds is one of the most common Roth IRA rollover mistakes.
There is a wealth of information regarding Roth IRA tax rules located on the IRS website. You may also be able to find IRS publications at your local post office or public library. If you need help understanding the rules surrounding Roth IRA accounts and rollovers, talk with your tax adviser or financial planner. When it comes to your future and your money, it’s a step well worth taking.