What are the Tax Consequences of a Rollover IRA/Roth IRA Conversion?

26 Apr

If you’re looking to rollover your IRA into a Roth IRA, you might be worrying about the amount of taxes you’ll need to pay when you make this rollover. Of course, your tax bill really depends on the situation of your rollover IRA. In traditional IRA’s rollover, the money that’s contributed to your account is taken out of your check before taxes are ever applied. When you take the money out during your retirement, it will be taxed accordingly. However, with a Roth IRA rollover, contributions are already taxed when they’re put into the account, so that when you take a Roth IRA distribution, it isn’t taxed.

Because of this difference in how taxes are applied to the two types of IRA accounts, you’ll need to be prepared to pay taxes on the amount that you’re moving over if you’re contemplating a Roth IRA conversion.  This can be a confusing task, so to be sure that the IRA to Roth IRA conversion goes well; you’ll probably want to perform a direct transfer so that the bank is responsible for managing the withdrawal of the taxes.  If you’re confused by this, don’t be – it is important that you understand the difference between the two types of transfers so that you can choose the best option for your needs.

The direct transfer mentioned above is a type of transfer that occurs completely between banks.  With this type of Roth IRA conversion, you’ll need to establish the new Roth IRA account, but beyond this, the bank will initiate the transfer of money from your existing account into the new account and will take care of any taxes that need to be reported to the IRS.

The other type of 401k Roth IRA conversion is known as an indirect transfer, and it works a little differently.  In this case, the existing IRA account is closed and a check is issued to you for only 80% of the total balance (the other 20% is withheld for tax purposes).  You then have 60 days total to open the new Roth IRA and deposit the money.  In most cases, the 20% would then be released into the new IRA, but with a Roth IRA conversion, the rules are a little different, which can lead to confusion.

Because of this confusion, many people opt to not complete a Roth IRA transfer from their existing IRA, but rather opt to roll the IRA into another traditional IRA and then open up a separate Roth IRA account to receive new contributions.  This is a possibility, and it can alleviate some of the stress involved with Roth IRA taxes.  This way, the money that you’ve already have set aside in a tax-deferred account is left alone, and you’re free to make future deposits into the Roth IRA account.  Whichever way you choose to go, you’ll need to make sure that the taxes are handled properly, as mistakes here could cause problems later on.

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