Traditional IRAs and Roth IRAs are two types of individual retirement accounts that provide financial benefits for saving money. Traditional IRAs are tax-deferred accounts while Roth IRAs offer after-tax savings. If your financial circumstances change, you may want to convert your traditional IRA to a Roth IRA. However, you need to consider the benefits and drawbacks before you do so. If you decide to convert, knowing how to report it can help you avoid extra tax penalties.
You can convert your existing traditional IRA to a Roth IRA either through a transfer or a rollover. A transfer is the simplest option, which involves the financial institution -- or institutions, if you are moving it to a Roth IRA at a different institution -- moving the money directly from the traditional IRA to the Roth IRA. With a rollover, the financial institution pays you the money from your traditional IRA and you then have up to 60 days to put the money into your Roth IRA.
Moving the money from a traditional IRA to a Roth IRA requires you to report the conversion on your income taxes because the money went from a tax-deferred account to an after-tax account. First, you must complete form 8606 to determine the taxable amount of the conversion. Barring you having made nondeductible contributions to the traditional IRA, the entire amount counts as taxable income. Then you must report the amount as a taxable IRA distribution on line 15b of form 1040. If you had any income taxes withheld from the transfer, you can report those on line 61 of form 1040 and this will reduce your taxes owed.
Roth IRAs let account holders take tax-free withdrawals from the account when they meet the conditions for taking qualified distributions. If you think that you will fall in a higher income tax bracket during the years that you are taking money out of the account than the year you are making the conversion, this can result in significant tax breaks. Also, the IRS does not force you to take withdrawals from your Roth IRA in the same way that minimum required distributions are required from traditional IRAs starting at age 70 1/2.
When you convert money from a traditional IRA to a Roth IRA, you must include the entire amount (except any nondeductible contributions, which are uncommon) as taxable income. Depending on the size of your conversion, this could push you into a higher income tax bracket and leave you with a larger tax bill than you anticipated. For example, if you fall in the 25 percent income tax bracket and convert $20,000 from a traditional IRA to a Roth IRA, you would owe an extra $5,000 in taxes that year. Also, you must wait at least five tax years before you can take qualified withdrawals of the money from the Roth IRA, even if you reach age 59 1/2 before that time.
- tax forms image by Chad McDermott from Fotolia.com