When you were first presented with the option of choosing a retirement savings account, you probably selected a traditional IRA instead of a Roth. this choice makes sense for most families, especially younger ones, due to the the initial tax savings. Congratulations on recognizing the wisdom of tax-advantaged savings! However, at this point in your life, it's possible you might want to change your mind and opt for tax-free retirement income instead. Making this switch is called a Roth conversion. Should you consider taking advantage of this opportunity, or are you better off sticking to your current savings strategy? Keep reading to find the facts you need to make a good decision.
What Is a Roth Conversion?
A Roth conversion refers to the act of converting a traditional IRA account into a Roth IRA account. A traditional IRA account is created using pre-tax dollars, meaning the distributions you take from a traditional IRA account in retirement are taxable. A Roth IRA is created using after-tax dollars, meaning the distributions you take from a Roth IRA account in retirement are tax-free (because tax has already been paid).
Additionally, a Roth IRA can be an appealing option for some because it does not include a required minimum distribution age. This means that you can continue to save and grow tax-free dollars for the remainder of your life.
Considerations to Make Before Doing a Roth Conversion
While a Roth conversion could be a great option for some, it could be a costly mistake for others. That’s why we’ve outlined four important considerations to make before converting your traditional IRA into a Roth account.
Consideration #1: Your Timeline to Retirement
If you’re retiring within the next few years, you may want to forego a Roth conversion. Why? Because the money you convert into a Roth IRA must stay there for a five-year holding period. If withdrawals are made within the first five years, you could be hit with a 10 percent penalty and/or additional income taxes.
Consideration #2: Tax Obligations
When considering a Roth conversion, take time to calculate the tax implications associated with this move. While your aim may be tax-free income in retirement, you will have to pay taxes on that income at some point. In the year of a Roth conversion, you will need to be prepared to pay taxes on the amount converted, which is considered additional income. This could very well push you into a higher tax bracket. While it’s possible to pay the additional taxes using a portion of the distribution itself, this is typically not advised for two reasons: you’d be robbing your future retirement of income and you may be subject to a 10 percent penalty for taking the funds.
Consideration #3: Your Future Tax Bracket
One of the main reasons an individual chooses to do a Roth conversion is for the advantage of tax-free withdrawals in retirement. With that in mind, you’ll want to take into consideration whether your tax bracket will be higher or lower in the future when you anticipate withdrawing the funds. If you believe you’ll be in a lower tax bracket during retirement, it may be worth leaving your traditional IRA in place and waiting to withdraw the funds then. On the other hand, if you’ve experienced a year of or lowered income (lost a job, missed out on a bonus, etc.), or you expect similar/higher income during retirement, you may be in a lower tax bracket now than you would when entering retirement and a Roth conversion this year would be wise.
Consideration #4: How Much to Convert and When
The good news is that you don't have to convert the whole traditional IRA to a Roth at once. If you’re on the cusp of a higher tax bracket, but still want to do a Roth conversion, you have the option to convert a portion at a time. By spreading the conversion across several years (as opposed to one lump sum), you can lower your yearly tax obligation.
How to Make a Roth Conversion
The IRS offers three possible ways for an individual to convert funds from a traditional IRA into a Roth IRA account. These methods include:
- Rollover: You receive the funds from your traditional IRA and must put the funds into a Roth IRA account within 60 days.
- Trustee-to-trustee transfer: The institution currently housing your traditional IRA transfers the distribution to a different institution where it'll be held in a Roth IRA.
- Same trustee transfer: The institution currently housing your traditional IRA is able to also house your Roth IRA, and they roll the account over for you.1
Being able to withdraw income tax-free in retirement is an appealing option for many. And it’s good to know that while you may have chosen to open a traditional IRA years ago that you have the option to convert it at any time. Before making any changes to your retirement savings account, make sure to speak with your fee-only financial advisor first. Together, you can go over these important considerations in regard to your unique financial situation.
This content is developed from sources believed to be providing accurate information, and provided by Twenty Over Ten. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.