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Converting to a Roth IRA

Converting to a Roth IRA

Roth IRAs are a valuable retirement planning tool, as they offer a source of tax-free income after you retire. And since the federal government relaxed conversion rules in 2010, even high-income earners have been able convert to Roth IRAs. But despite some advantages, Roth IRA conversions aren’t right for everyone. 

What Is a Roth IRA Conversion?

In simplest terms, a Roth conversion involves changing the tax treatment of your retirement savings. Generally, contributions to a traditional IRA are tax deductible in the year you make them (contributions may be allowed but not deductible if your income exceeds certain limits). The money you contribute grows over time; and when you start making withdrawals in retirement, you pay taxes on the money you take out.

Contributions to Roth IRAs, on the other hand, aren’t tax deductible in the year they are made.

But earnings grow tax free; and when you withdraw the money, you don’t pay any federal income taxes. A Roth IRA conversion involves taking funds from a traditional IRA, paying tax on any previously untaxed funds, and then putting the funds in a Roth IRA so that you can have tax-free income in retirement. 

Roth IRA Conversion Pros

For anyone who suspects they may be in a higher tax bracket in retirement, converting to a Roth IRA may be appealing. Roth IRA conversions may also be a smart move if the value of your IRA has recently dropped because you’ll pay less tax on the conversion, or if you have other deductions or credits you can claim to help offset the tax on the converted amount. If you’re young and in a relatively low tax bracket, Roth IRAs are also advantageous since you won’t get much of a tax break from current deductible contributions and your taxes are likely to be higher in the future.

People who have significant assets may also use Roth IRA conversions as an estate-planning tool. If your other assets will be sufficient for your retirement income needs and you don’t anticipate a need to make withdrawals from your Roth IRA during your lifetime, you may want to use it as a way to leave tax-free income to your heirs. Since there are no required minimum distributions from a Roth IRA, the money can grow undisturbed during your lifetime, plus the distributions to your heirs should be free of income tax.

Roth IRA Conversion Cons

When is it not a good idea to convert to a Roth IRA? If the steep tax bill required for converting makes you squirm, a Roth IRA conversion may not be for you. After all, if you’re in the 28% tax bracket and convert a $100,000 IRA, you’ll owe $28,000 in taxes. Most experts also recommend using cash to pay the tax on conversion to avoid depleting your retirement savings. Paying the taxes with cash is especially critical if you are under age 59½, since using money from your IRA to pay the tax will result in a 10% penalty on the amount that’s not rolled over into the Roth IRA. Likewise, if you plan on spending the Roth funds early on in retirement (within five years of the conversion), you may not have enough time for earnings in the Roth IRA to make up or taxes paid on the conversion.

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