If you're looking to set aside money so you can take tax-free distributions when you retire, a Roth individual retirement arrangement could be just what you're looking for. However, the Internal Revenue Service imposes income restrictions on who can contribute directly to a Roth IRA. Some of these high earners, however, use a traditional IRA contribution to get money into a Roth IRA.
No Time Limit
The IRS does not require that you leave the money in the traditional IRA for any specified length of time before you convert it to a Roth IRA. As a result, you can immediately convert your traditional IRA contributions to a Roth IRA. This effectively allows you to circumvent the income tax restrictions on who can convert to a Roth IRA, regardless of your modified adjusted gross income.
Taxes on Conversions
When you convert money from a traditional IRA to a Roth IRA, you generally have to include the amount of the conversion in your taxable income for the year because you're moving money from a tax-deferred account to an after-tax account. For example, if you make a $5,000 deductible contribution to a traditional IRA and then convert it to a Roth IRA, you have to include that $5,000 in your taxable income. However, your qualified distributions will be tax-free.
Nondeductible Contribution Effects
If you've made non-deductible contributions to any traditional IRA, that portion of your conversion isn't taxed because you didn't receive a deduction for the contributions. However, you can't pick and choose which parts of your traditional IRA you want to convert. Instead, the composition of the conversion depends on your total nondeductible contributions and total traditional IRA value at the time of the conversion. For example, if you've made $12,000 of nondeductible contributions and the total value of your traditional IRA is $100,000 at the time of the conversion, 12 percent is tax-free.
Conversion Tax Rates
The tax rate on your conversion depends on your filing status and your other taxable income for the year. The taxable portion of the conversion simply adds to your taxable income for the year. For example, if you fall squarely in the middle of the 26 percent tax bracket and your conversion of $5,000 to a Roth IRA is fully taxable, you would pay $1,300 in income taxes.
Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."