When opening an IRA retirement savings account, you’re typically presented with the option of choosing between a traditional or Roth IRA. While you may have stuck with a traditional IRA for the initial tax savings, it’s possible you could change your mind and opt for potential tax-free retirement income instead. Making this switch requires a technique called a Roth conversion. Should you consider taking advantage of this opportunity, or are you better off sticking to your current savings strategy? We’re discussing what you need to know below.
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. This means that you expect to get a tax deduction with your initial contributions, and your future distributions during your retirement years are taxable income. A Roth IRA uses after-tax dollars, which means there is no upfront tax deduction. The trade-off, however, is that future distributions you take from a Roth IRA account in retirement can be tax-free (because tax has already been paid).
Roth IRAs can be an appealing option for some because they do not have a required minimum distribution during the owner’s lifetime. This means that you can continue to save and grow tax-free dollars for the remainder of your life. These tax-free dollars can also be passed down to your beneficiaries. However, people who inherit a Roth IRA account will have to take required minimum distributions.
Considerations to Make Before Doing a Roth Conversion
While a Roth conversion could be a great strategy for some, it could be a costly mistake for others. We have outlined some 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 withdraws are made before the five years is up, you could be hit with a 10 percent penalty and/or additional income taxes.
Consideration #2: Tax Obligations
When considering a Roth conversion, you simply can’t ignore the tax implications associated with this move. While your aim may be tax-free income in retirement, you will have to pay taxes on the amount you convert at your current tax rates. This additional income could push you into a higher marginal tax bracket. It is possible to cover the difference using a portion of the distribution itself; however, 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. If you believe you’ll be in a lower tax bracket during your retirement years, it may be worth waiting to withdraw the funds then. On the other hand, if you’ve experienced a year with interrupted or lowered income (lost a job, missed out on a bonus, etc.), you may be in a lower tax bracket now than you would when entering retirement.
Some clients that have been able to accumulate large IRA accounts over their working years may want to consider the impact of future RMD requirements on their tax situation. Some clients that have strong retirement income from social security and pensions may not require much money from their savings in the early years of retirement. However, qualified retirement accounts must begin distributing funds when the owner turns 72. Clients can potentially use Roth Conversions to smooth out their tax obligations over time, instead of getting hit with a tax torpedo when they turn 72.
Consideration #4: How Much to Convert and When
If you’re on the cusp of a higher tax bracket, but still want to do a Roth conversion, you do 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.
Another opportunity that may present itself periodically is when we experience a bear market with our investments. Bear markets occur when equity markets drop at least 20% from a previous high. The volatility for some bear markets can be unnerving, but it’s an opportunity to convert IRA assets to Roth assets when there is a substantial discount.
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 are given the funds 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 moves to your retirement savings account, make sure to speak with a financial planner. There are rules when it comes to Roth conversions, and each person should consider their own situation carefully before taking action. We always recommend making financial decisions like this in the context of a financial planning strategy.
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.