If you are considering the conversion of a Traditional IRA to a Roth IRA, there are a number of factors to consider. Let’s begin by looking at some key differences between these two retirement accounts.
With a Traditional IRA, contributions may be tax deductible in the year(s) they are made. Taxes don’t have to be paid until one begins withdrawing from the account. (There is a penalty for making IRA withdrawals before age 59½.) Withdrawals are taxed as ordinary income based on one’s tax bracket.
Roth IRA contributions, on the other hand, are not tax deductible. In fact, taxes are paid up front based on one’s income. For example, if you contributed $5,000 and were in the 12% tax bracket you would be taxed $600 and your post-tax contribution to the Roth would be $4,400. However, withdrawals from a Roth IRA are tax free as long as you are 59½ and have held the account for five years or more.
As you would imagine, these differences have major implications for tax and estate planning. Now let’s look at some advantageous to converting a Traditional IRA to a Roth IRA.
- As I mentioned, qualified withdrawals from a Roth IRA are tax-free, unlike Traditional IRAs where withdrawals are taxed as ordinary income. This means you could save a significant amount in taxes over the long run with a Roth IRA, especially if you expect to be in a higher tax bracket when you begin to make withdrawals.
- Roth IRAs are not subject to Required Minimum Distributions during your lifetime, giving you more control over your retirement income and allowing money to continue to grow tax-free.
- Roth IRAs can be passed to beneficiaries tax-free, potentially minimizing your loved ones’ tax liabilities and maximizing your legacy.
All well and good. But there are certain situations where a Roth conversion may not be a great idea.
- Since Roth IRA contributions are taxed up front, conversions from your Traditional IRA to a Roth IRA are considered taxable income in the year of conversion. This could push you into a higher tax bracket and lead to a larger tax bill in the year of the conversion.
- Converted funds must remain in your Roth IRA for at least five years to be eligible for tax-free and penalty-free withdrawals of earnings in retirement. If you anticipate needing the money within five years, a Roth conversion might not be the best strategy.
- If you believe your tax rate will be significantly lower upon retirement, a conversion might not make sense because the taxes you pay on Traditional IRA withdrawals may be less than the taxes paid on the conversion to a Roth.
As with so many other aspects of estate planning there is no one-size-fits-all approach. A proper plan depends upon your unique goals and situation. Given the fact that Roth conversions are permanent and cannot be undone, I strongly recommend speaking to a financial or tax advisor before deciding to convert a Traditional IRA to a Roth IRA.
Until next time, take care…