Most of us know there are two types of IRAs: traditional and Roth. You may even know that there are tax differences between the two, and it’s possible you have both of these savings vehicles in your retirement arsenal. What you may not know is that your traditional IRA can be converted to a Roth IRA. But like any financial decision, what’s right for someone else may not be right for you. Let’s look at the ins and outs of a Roth conversion to see if it would benefit your financial situation.
First, let’s refresh our memories on the two primary differences between traditional IRAs and Roth IRAs: taxes and income restrictions. As a quick review, traditional IRAs allow you to save on taxes now and pay them at a later date when your income is traditionally lower. Roth IRAs are funded with after-tax money, and withdrawals in retirement are tax-free.
Aside from tax treatment, Roths have income restrictions, whereas traditional IRAs don’t. In 2019, a single person making above $137,000 cannot contribute to a Roth, and if they make over $122,000, the amount they can contribute begins to phase out. For a married couple filing jointly, the phase-out range is $193,000-$203,000.
You may be drawn to a Roth conversion for many reasons. For example, a conversion bypasses the income limitations. If you make too much to be eligible for a Roth, you can pay the taxes to convert your traditional IRA to a Roth and still reap the benefits.
Then, on top of the tax-free growth perk, Roth IRAs are great because they don’t require you to start taking distributions when you’re 70½ like all the other retirement plans out there. In fact, instead of taking money out, you can keep putting money in. Also, they have favorable rules for your heirs, so your account can keep growing tax-free for years after you are gone.
Also, when you convert your IRA, you pay taxes now so that you don’t have to when you make withdrawals in the future. Roths also have more flexible withdrawal rules, which is an attractive feature to many. Finally, if you have a substantial IRA, you can reduce the number of your RMDs by converting a portion of it to a Roth, keeping you in a lower tax bracket when it comes time to start taking withdrawals.
So the big question is, should you convert your IRA or hold onto it?
Simply put, the tax hit from a conversion could be substantial and time may not be on your side. Remember that the amount withdrawn from the traditional IRA counts toward your annual income, so know your numbers and don’t let the conversion push you into a higher tax bracket for the year.
That’s why the timing of conversion is important. If you find yourself in a lower tax bracket due to unemployment, medical expenses, business loss, or significant tax credits, it might be worth it to convert now. If you expect your income and tax rate to increase in the years to come, now would be the ideal time to make the change. Regardless of when you make the change, ensure you have the resources available to pay those extra taxes on the withdrawal. If the only extra money you have is from the IRA account itself, you are cheating yourself out of the chance for those funds to grow and compound tax-free in the Roth.
Another factor to consider when making this decision is your age. If you convert a substantial traditional IRA to a Roth when you are in your 50s or 60s, it could take a decade or more for the IRA to recapture the dollars lost to taxes on the conversion. The younger you are when you convert a regular IRA to a Roth, the better.
Your choice is based on your situation. If you think you will be in a higher tax bracket as you get older, paying the taxes on a Roth now instead of on a traditional IRA later might be your best bet. But since many retirees have lower income than when they worked, they may retire to a lower tax rate, making a traditional IRA the better choice.
And since no one can predict the future of American taxation, some people contribute to both types of retirement accounts to balance their taxation risk.
The bottom line is this: a Roth conversion is an advantageous way for high-income earners and traditional IRA account earners to access the benefits of a Roth IRA. However, because of the many tax implications, you need to be careful. It’s important to work with an experienced financial professional to ensure you are making the most of your investments and not paying more taxes than necessary.
If you’re ready to weigh your options, I can help you determine if a Roth conversion is a good fit for you and strategize proper implementation. I can also help you analyze if you should be more diversified in your retirement savings or address your in-service distribution options. Schedule a call and meet me virtually to get started!