For Mark Roberts’ Use:
Many taxpayers wait until after their taxes are calculated to find out whether their income allows them to contribute to a Roth IRA. Sometimes those who are over the income limit choose to contribute to a traditional IRA instead, and then immediately convert the money to a Roth IRA. One question that often comes up is whether waiting until after tax time to make this decision is really prudent or necessary. The other option, of course, is to just automatically contribute to a traditional IRA anyway, and convert the money to a Roth IRA every year. Many taxpayers with no deductible IRAs wonder if they should even bother waiting to see if they are eligible to contribute straight to the Roth IRA.
The main difference between these two scenarios lies in how the contributed funds are treated after the fact. When individuals make Roth IRA contributions directly, the funds can be withdrawn at any time without being subject to a 10 percent early distribution penalty. The withdrawn funds are also not subject to federal taxes.
On the other hand, when funds in a traditional IRA are then converted to a Roth IRA, the money is treated differently. Funds which were converted into the Roth IRA via this back-door method are subject to a five-year waiting period for individuals under age 59 1/2. During this time, the converted funds cannot be withdrawn without the 10 percent withdrawal penalty.
It is important to note that each conversion is treated separately, so each time an amount is converted into a Roth IRA that portion of funds is subject to the waiting period. Also, direct contributions are deemed to be distributed first, with conversions following. What goes in first, comes out first.
Depending upon each individual’s circumstances, these rules may or may not be bothersome. They are, however, something to keep in mind when making decisions about traditional and Roth IRA contributions.