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 discuss what you need to know.
What Is a Roth Conversion?
A Roth conversion refers to the act of converting a traditional IRA or 401(k) account into a Roth IRA account. A traditional retirement account is created using pre-tax dollars, meaning the distributions you take from a traditional IRA or 401(k) account in retirement are treated as 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 the tax has already been paid).
Additionally, a Roth IRA can be an appealing option for some because it does not have a required minimum distribution age. This means that you can continue to save and grow tax-free dollars for the remainder of your life.
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 we’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 withdraws are made before the five years is up, you could be hit with a 10 percent penalty and/or additional income taxes. It is important to make sure that you have other funds available to satisfy your income needs during this five year period.
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 at some point. Completing a Roth conversion means that you must pay the income taxes on the conversion amount now versus paying the income taxes in the future on your traditional IRA withdrawals.
When a Roth conversion is completed, the amount converted is included in your income for the year. Just to reiterate, while a Roth conversion does provide a future tax benefit, it does come with a current cost. Due to this fact, a Roth conversion is a double-edged sword. While a Roth IRA can provide tax-free income in retirement and eliminate or reduce the impact of other income-based costs, the conversion itself increases your current income as well as your current tax bill. A key factor to remember when considering a Roth conversion is where your income is in relation to the marginal tax bracket. A conversion could very well push you up into a higher tax bracket.
While it’s possible to cover the additional tax liability using a portion of the Roth conversion distribution itself, this is typically not advised for two reasons: you would be robbing your future retirement of income and you may be subject to a 10 percent penalty for taking the funds out of your IRA before the age of 59 1/2.
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.
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.
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 involving your retirement savings accounts, make sure to speak with your financial advisor first. Together, you can go over these important considerations with regards to your unique financial situation.
This content is developed from sources believed to be providing accurate information. 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.