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Roth IRA conversion considerations

When opening a 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 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? 

Let's take a look.

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 usually created using pre-tax dollars, meaning the distributions you take from a traditional IRA account in retirement are taxable income.  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). 

Bear in mind, certain rules must apply for this money to come out tax-free. 

Additionally, a Roth IRA can be an appealing option for some because it does not include a required minimum distribution age of 72 like non-Roth accounts do. This means that you can continue to save and grow tax-free dollars for the remainder of your life. (and potentially someone else's life as well)

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 I’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 certain 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 that income in the year of conversion. You need to be prepared to pay the taxes on this additional income, which could very well push you up into a higher tax bracket. While it’s possible to cover the difference 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 come retirement, it may be worth waiting to withdraw the funds then. On the other hand, if you’ve experienced a year of 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. This could make a Roth conversion more attractive.

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. 

Consideration #5:How Much Income You Will Need in Retirement

If for example, you need more than your required minimum distribution from a traditional IRA during retirement to meet your expenses, a Roth conversion might not make sense as this account could be depleted in too short a time from to warrant paying those taxes upfront.

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 your financial advisor first. Together, you can go over these important considerations in regards to your unique financial situation. 

  1. https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-iras-rollovers-and-roth-conversions

As always, please feel free to reach out to me anytime for a conversation.   Click HERE

In good health.

All the best.

Rick Fingerman, CFP®

Rick@PlanWithFPS.com

617-630-4978

*This blog article is meant to be just a simple primer. I'm happy to speak in more detail one on one. 

Financial Planning Solutions, LLC (FPS) is a Registered Investment Advisor. Financial Planning Solutions, LLC (FPS) provides this blog for informational and educational purposes only. Nothing in this blog should be considered investment, tax, or legal advice. FPS only renders personalized advice to each client. Information herein includes opinions and source information that is believed to be reliable. However, such information may not be independently verified by FPS. Please see important disclosures link at the bottom of this page.

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