FINRA Series 6 Investment Company and Variable Contracts Products Representative ExaminationOpening and Maintaining Customer Accounts and Investment RecommendationsMedium
A client, age 50, has an existing traditional IRA and is considering converting a portion of it to a Roth IRA. They anticipate being in a lower tax bracket in retirement than they are currently. What is the primary tax implication the registered representative should explain to the client regarding this conversion?
- AFuture qualified withdrawals from the Roth IRA will be tax-free.
- BAll contributions to the Roth IRA will be tax-deductible.
- CThe converted amount will be subject to ordinary income tax in the year of conversion.
- DThe client will incur a 10% early withdrawal penalty on the converted amount.
Show answer & explanationAnswer & explanation
Correct answer: C. The converted amount will be subject to ordinary income tax in the year of conversion.
Converting a traditional IRA to a Roth IRA requires the investor to pay ordinary income tax on the converted amount in the year of conversion, as traditional IRA contributions are typically made pre-tax or tax-deferred. This is a crucial consideration, especially if the client is in a higher tax bracket currently.
Why the other options are wrong
- A. While true for future qualified withdrawals, this is a benefit of the Roth IRA, not the primary tax implication of the *conversion* itself.
- B. Roth IRA contributions are never tax-deductible; they are made with after-tax dollars.
- D. A 10% early withdrawal penalty typically applies to withdrawals of earnings before age 59½, not to the conversion itself, although the converted amount does become taxable.
Traditional to Roth IRA Conversion Tax
When converting a traditional IRA to a Roth IRA, the converted amount (excluding any non-deductible contributions) is treated as taxable income in the year of conversion and subject to ordinary income tax.
- Converted amount is taxable as ordinary income
- Tax paid in the year of conversion
- Applies to pre-tax contributions and earnings
- Future qualified withdrawals are tax-free
Memory trick: Converting means you pay the taxman NOW, for tax-free later.