IRA Conversions and What They Mean for You

After the advent of the Roth IRA with the 1997 Taxpayer Relief Act, many people have decided to convert their traditional IRAs to Roth IRAs. There are ample benefits to doing so, but drawbacks also exist and must be measured carefully.

In order to perform a conversion in the first place, you have to be eligible to do so. One barrier that can keep you from converting to a Roth IRA is your Adjusted Gross Income, which cannot be greater than $100,000 in the year in which you wish to perform the conversion. It is important to note that the money you decide to convert from a traditional IRA that was not taxed before will be added to your Adjusted Gross Income and all of your income will be taxed at the higher rate. In effect, you will be trading a bump in your taxes in the short term for the long term tax advantages associated with a Roth IRA.

The main advantage of converting (or "rolling over") your traditional IRA into a Roth IRA is the long term tax benefits that the latter plan offers. Because you are transferring funds from one IRA account to another, albeit of a different kind, you are not subject to the normal 10% penalty that a regular early withdrawal would occur. You should note, however, that the funds from your traditional IRA still cannot be taken out of your Roth IRA early, otherwise you will suffer the 10% penalty.

There are two methods for converting from a traditional employee-based IRA to a personal Roth IRA account. A direct transfer is when your employer simply transfers the funds in your former account into your personal Roth IRA, so you never personally handle the funds. In an indirect transfer, your employer gives the money in your former account to you directly. You then have up to 60 days to contribute all or part of the funds to your Roth IRA and still avoid paying any kind of penalty.

Though many consumers have decided to take advantage of the benefits of an IRA conversion, it is not necessarily the right move for everyone. The benefits depend on personal factors such as age, time in the workforce, time left before retirement, income level, marriage status, and personal preference. There are a number of conversion calculators available that can help you determine whether or not a conversion would be advantageous to you in the long term. Of course, going over your options with a qualified professional is the best way to determine the correct course for you.