In 2010 the IRS changed its income limitations on a strategy known as a Roth conversion, which is the process of transitioning funds from a traditional IRA into a Roth IRA. Prior to that point, you could execute a Roth conversion only if your income was below a specific limit. After the change, the Roth conversion became available to nearly everyone.
Since 2010, more and more retirees and workers approaching retirement have considered whether a Roth conversion is right for them. If you’re thinking about converting your traditional IRA, you’re not alone.
While a Roth conversion may offer some unique benefits, it’s not for everyone. The decision to convert should be based on your specific needs and objectives. Below are four questions to ask yourself to guide your thinking. After considering these questions, you should be more informed about how a Roth conversion could impact your retirement planning.
What are your tax obligations likely to be in retirement?
Very often, the decision to convert an IRA is motivated by tax concerns. With a traditional IRA, you enjoy upfront deductions for your contributions. The assets grow on a tax-deferred basis as long as the money stays in the IRA. When you take a withdrawal, though, the entire distribution is taxable as income.
In a Roth IRA there are no upfront deductions. Like a traditional IRA, a Roth doesn’t require you to pay taxes on growth that happens inside the account. However, your withdrawals from a Roth IRA are tax-free, and they don’t count toward your taxable income.
That means you not only avoid taxes on your Roth distributions, but you also may have less taxable income, which could impact your tax rate and the amount of taxes you face on other sources of income, like Social Security. If you think taxes could be a challenge for you in retirement, a Roth conversion may be an effective strategy.
Do you want to avoid distributions from your IRA?
In a traditional IRA, you’re required to take distributions starting at age 70½. If you don’t take a distribution, you could face heavy taxes and penalties. As you get older, the distribution percentage increases, and it’s possible that you could deplete your IRA if you live well past 70.
There are no required distributions with a Roth IRA. That may be appealing if you have no desire to take income from your account. You may simply wish to let your assets accumulate so you can leave a sizable, tax-free benefit to your loved ones.
Do you have the funds available to pay the taxes from the conversion?
Since traditional IRA distributions are taxable and Roth distributions are not, there has to be a settling of the tax obligation during the conversion process. You will have to pay taxes on the growth and the deductible contributions in your traditional IRA.
This is preferably done with non-IRA assets. Although you can withhold the taxes from your traditional IRA conversion amount, doing so may negate some of the benefit of the conversion. After all, you want as much money as possible going into the Roth to take full advantage of the unique tax structure. If you don’t have other funds to pay the taxes, you may want to think twice before converting.
Do you need income within five years?
Distributions from a Roth IRA are tax-free, but only if they meet qualification criteria. The first criterion is that there must be a qualifying event. The three qualifying events are being age 59½ or older, disability or death. The other qualification criterion is that the account has to have been open for at least five years. If you need income from your IRA within five years, a conversion may not be a good idea, as you won’t be able to take the distributions on a tax-free basis.
Are you ready to consider a Roth conversion? If so, contact us at Retirement Income USA in Rockland, Massachusetts. We can help you analyze your needs and goals and determine the appropriate strategy. Let’s connect today and start the conversation.
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