IRA accounts are retirement savings accounts that have a tax savings element. There are two types of IRA accounts- Traditional IRA accounts are accounts that allow a taxpayer to save for their retirement tax free subject to a maximum. Once the taxpayer retires, the distributions are taxes. Roth IRA accounts work in the opposite way. Contributions to a Roth IRA account are after tax but the growth and withdrawals of the funds is tax free. A taxpayer can choose to invest in either of the two IRA accounts. People with a high tax rate are advised to go for traditional IRA so that they can pay tax on retirement when their tax rate lowers. On the other hand, those who have a low tax rate such as those who are starting out on their career are advised to take a Roth IRA as they pay tax upfront when their tax rate is low in exchange for tax free distributions on retirement.
Conversion of IRA Account
The tax code also allows for a taxpayer to convert a traditional IRA into a Roth IRA. In this case, the taxpayer pays income tax on the balance of the traditional IRA at the highest of his or her income tax rate so as to convert to a Roth IRA. This move is ideal when the market comes down and the balance in the accounts is low. Many investment advisers advised their clients to transfer their traditional IRAs into Roth IRA in 2010 as the markets were low and therefore their IRA account balances were low. By making the a conversion when the balances were low, their tax liability was also low. They could then continue saving up in their Roth IRA to enjoy tax free funds on retirement. Those who converted traditional IRAs to Roth IRA in 2010 can take advantage of the 2-year-reporting tax break available only in 2010. This means that taxpayers who made the switch to Roth IRAs can pay the taxes due from this conversion in 2010 and in 2012. The taxpayer can also decided to pay the whole tax amount in 2010 by electing to do in the Form 8606, Part II.
Re-characterization of IRA Accounts
If you make a conversion from a traditional IRA into a Roth IRA, you still have an opportunity to convert it back to a traditional IRA within a given time period. The converting back into a traditional IRA is called re-characterization. For many people who opted for a conversion in 2010 had the opportunity for re-characterization as long as it was done before October 17th 2011. If they re-characterized, they simply reversed the move they made to a Roth account and therefore, will not pay the taxes that were due. This window allows taxpayers who change their mind to revert back to their traditional IRAs. Taxpayers who decide to go for a re-characterization after filing the 2010 tax return will need to file a tax amendment to finalize the reversal.