There are several kinds of IRAs, each with its own advantages. Switching between IRA types isn't easy. However, there is a process to move funds from a traditional IRA to a Roth IRA. Done correctly, a Roth IRA conversion is a tax-free, penalty-free way to transfer money into a Roth IRA from your traditional IRA.
Traditional IRA Fundamentals
A traditional IRA provides a way for retirement savings to grow tax-deferred. Qualifying taxpayers may also take a tax deduction for IRA contributions. However, there are two major drawbacks to a traditional IRA. First, IRA withdrawals are taxed as income. Second, once the account owner turn age 70 1/2, he must start taking required minimum distributions (RMDs) from the IRA.
Roth IRA Fundamentals
Like a traditional IRA, a Roth IRA offers tax-deferred growth on all money invested inside the account. Unlike a traditional IRA, Roth IRAs do not offer any possible tax deduction on contributions. Conversely, withdrawals made from a Roth IRA are tax-free in retirement. Furthermore, there are no required minimum distributions mandated from Roth IRA accounts. If you don't need the money, it can sit tax-free in a Roth IRA as long as you like and can even be passed on to your beneficiaries.
Roth IRA Conversions
Until 2010, Roth IRA conversions were restricted to certain taxpayers beneath an income limit. Beginning in 2010, the income limits were removed from Roth IRA conversions, making them available to all taxpayers regardless of income. There is no age limitation on Roth IRA conversions, nor is there a requirement that the taxpayer be employed. The only requirement is that if the taxpayer is age 70 1/2 or older and has already started taking RMDs, the amount due as an RMD for the year of the conversion must be withdrawn and cannot be converted. Any other amount may be converted at any age and under any employment status.
Roth IRA Five-Year Rule
Retirees should be aware of the five-year rule before converting to a Roth IRA. A Roth IRA must be opened and funded for at least five years before withdrawals are tax-free. That means if you are opening a Roth IRA for the first time as part of the conversion, you will have to wait five years to make tax-free withdrawals.
Furthermore, five years must pass after a Roth IRA conversion in order to withdraw converted funds tax-free. However, the five-year period for conversions is waived once the taxpayer turns 59 1/2. So if you are retired and under age 59 1/2, you won't be able to take advantage of tax-free withdrawals until five years is up, or you turn 59 1/2. If you are already over age 59 1/2, the five-year rule for conversions does not apply.