Is a Roth Conversion Right for You?

If you’re like many retirees, much of your retirement assets are in a qualified account such as a 401(k) or a traditional IRA. As pensions have become less common and workers have become more responsible for funding their own retirement, qualified accounts have offered a tax-advantaged way to save money.

When you contribute to a 401(k) or a traditional IRA, you may receive tax benefits immediately. Deductions for 401(k) plans are taken out of your check pretax, thus reducing your taxable income. Contributions to traditional IRA plans may be deductible depending on whether you meet income limitations.

After you contribute to a qualified plan, your assets can grow on a tax-deferred basis. That means you don’t pay taxes on your investment growth until you withdraw funds from the plan. That tax-deferral may help your assets grow at a faster rate than they would if you paid taxes on growth each year.

While qualified accounts are valuable savings tools, they can also create a tax issue in retirement. Distributions from 401(k) plans and traditional IRAs are treated as income for tax purposes. If tax rates are higher in retirement than they were when you contributed, those upfront deductions may not be as valuable.

One option is to convert your traditional IRA or roll your 401(k) into a Roth IRA. The Roth allows you to withdraw your funds on a tax-free basis as long as you meet qualification criteria. That means you could turn your traditional IRA or 401(k) into a tax-free retirement income stream.

Before you move forward with a conversion, however, there are a few things you should consider. Below are three important questions to ask yourself as you analyze whether a conversion is right for you:

Do you need the money within five years?

In order for your Roth withdrawals to be tax-free, the distribution has to meet qualification criteria. The first criterion is that you must be either 59½ or older, dead or disabled. Your Roth also has to have been open for at least five years. If it hasn’t been open five years, the distribution will be taxable. If you will need distributions within five years, a conversion may not be the right strategy for you.

Do you have money to pay the taxes on the conversion?

To maximize the benefits of the Roth, you likely want to convert as much money as possible. Remember, you will have to pay taxes on the growth and the deductible or pretax contributions that you convert. Although you can withhold those taxes from the converted amount, it may not be wise to do so. That withholding will reduce the amount that goes into your Roth.

The alternate strategy is to use other funds to pay the tax liability. If you don’t have the liquidity to cover the tax bill, you may want to think twice before doing a conversion.

What will you do with the Roth?

When you do a conversion, your assets enter the Roth IRA as cash. You then invest them according to your goals and risk tolerance. This may be a good time to reassess your strategy and make changes.

One option is to consider a tool that will provide guaranteed lifetime income. For example, annuities offer a number of different ways to generate guaranteed income from your assets. If you put the annuity inside a Roth, that income is not only guaranteed, but it’s also tax-free.

Interested in learning more about a Roth conversion? Contact us at Lighthouse Financial in Rocklin, California. We can help you analyze your needs and explore various strategies. Let’s connect soon.


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