Would converting from a traditional IRA to a Roth IRA be a smart move for you? Understand the tax implications before you decide.
The benefits of a Roth conversion
A Roth conversion refers to taking all or part of the balance of an existing traditional IRA and moving it into a Roth IRA.
Why you might convert a traditional IRA to a Roth IRA
Enjoy tax-free withdrawals in retirement
When taking withdrawals from a traditional IRA, you'd have to pay taxes on the money your investments earned—and on any contributions you originally deducted on your taxes.
With a Roth IRA, as long as you meet certain requirements, all of your withdrawals are tax-free.
Watch your money grow tax-free for longer
Traditional IRAs force you to take required minimum distributions (RMDs) every year after you reach age 72 (age 70½ if you attained age 70½ before 2020), regardless of whether you actually need the money. So you lose the tax-free growth on the money you had to withdraw.
On the other hand, Roth IRAs don't have RMDs during your lifetime, so your money can stay in the account and keep growing tax-free.
Leave a tax-free inheritance to your heirs
The people who inherit your Roth IRA will have to take RMDs, but they won't have to pay any federal income tax on their withdrawals as long as the account's been open for at least 5 years.
A conversion can get you into a Roth IRA—even if your income is too high
The conversion would be part of a 2-step process, often referred to as a "backdoor" strategy.
First, place your contribution in a traditional IRA—which has no income limits. Then, move the money into a Roth IRA using a Roth conversion.
But make sure you understand the tax consequences before using this strategy.
Other questions to consider
Deciding whether to convert to a Roth IRA hinges on issues like your tax rate now versus later, the tax bill you'll have to pay to convert, and your future plans for your estate. And remember, the conversion will be permanent—you can't revert the money back to a traditional IRA.
It's best to talk with a tax advisor before you make your decision. In the meantime, here are a few things to consider.
Will you need the money in 5 years or less?
There's a 5-year holding period on withdrawals of money that were part of a Roth conversion. So if you think you'll need the money within that time, you could end up owing the taxes you were hoping to minimize with a conversion.
Will you end up in a higher tax bracket?
All or a portion of the money you convert could be considered "reportable income" by the IRS. If you're on the cusp of the next tax bracket, there's a chance you'll get bumped up in the year you convert.
To avoid this, consider converting a portion of your traditional IRA. This could help you:
- Stay out of that higher tax bracket.
- Spread the taxes related to the conversion over a few years instead of getting hit with the entire bill in 1 year.
Will your tax bracket be higher now or later?
No one really knows how tax rates could change over the next 5, 15, or 25 years.
If you believe your tax rate is lower now than it will be when you start taking withdrawals, a conversion may look promising because you'll pay conversion taxes while you're in a lower tax bracket and enjoy tax-free Roth IRA withdrawals later (when the higher tax bracket won't matter).
But if you believe your tax rate is higher now than it will be when you start taking withdrawals, a conversion could cost you more in taxes now than you'd save with tax-free withdrawals later.
So what do you do? It may help to "diversify" your taxes—in other words, pay some of the taxes now (when you're still building your retirement savings) and save some for later (when you need that money to cover expenses in retirement).
Give this some thought and talk with your tax advisor about what might be best for you.
Where will you get the money to pay the conversion taxes?
Before you use money from your IRA to pay the tax bill, consider the following:
The money taken out of your IRA to pay conversion taxes would be considered a distribution. This could result in even higher taxes in the year you convert.
In addition, if you're younger than age 59½ and you withdraw money from your IRA to pay conversion-related taxes, you could also face a 10% federal penalty on that withdrawal.
You'll lose the chance for that money to compound and grow tax-free in your IRA—which means less money when you need it in retirement.
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Most owners of traditional IRAs and employer-sponsored retirement plan accounts (like 401(k)s and 403(b)s) must withdraw part of their tax-deferred savings each year, starting at age 72 (age 70½ if you attained age 70½ before 2020). If you withdraw less than the RMD amount, you may owe a 50% penalty tax on the difference. Roth IRAs have no RMDs during the owner's lifetime.
The snowball effect that happens when your earnings generate even more earnings, not only on your original investments, but also on any interest, dividends, and capital gains that accumulate. That means that your "money makes money" and can grow faster over time.