There are many options when it comes to retirement, and it can be hard to know which is right for you. One of those options – a ROTH IRA conversion, can be a great strategy for some people.
First, a quick refresher on how a ROTH IRA differs from a Traditional IRA.
With a Traditional IRA:
1. You receive an upfront tax deduction on your annual contributions
2. Growth is tax-deferred growth until it’s withdrawn
3. Withdrawals are taxable as ordinary income
4. There are penalties if you take withdrawals before the age of 59 ½
5. You have required minimum distributions (RMDs) that begin at age 70 ½
With a ROTH IRA
1. Your contributions are “front loaded” meaning you use after-tax dollars for your contributions
2. Growth is tax-free
3. Withdrawals are never taxed
4. Earnings can be taken income-tax-free if you are at least 59 ½ and have had the ROTH IRA for at least 5 years
5. There are no required minimum distributions – ever!
If you currently have a Traditional IRA, but some of the benefits of a ROTH IRA sound appealing to you, there is a way to “convert” your traditional IRA into a ROTH IRA – this is what’s meant by a ROTH conversion.
In making a conversion, keep in mind that you can convert a portion or all of your traditional IRA into a ROTH and enjoy tax-free withdrawals after retirement. However, a conversion might not be for everyone. When you consider a conversion you should consider the following:
1. Your current tax bracket vs. your future tax bracket
A ROTH conversion makes sense if you will be in same or higher tax bracket when your withdrawals will be made, since it essentially allows you to “lock in” your current tax rate. A traditional IRA might be better if you will retire into a lower tax bracket.
2. Your time horizon
A ROTH makes sense if you have many years before needing to withdraw the money in retirement. Many people only take the RMDs required by traditional IRAs because they are forced to by the tax law. The ROTH IRA eliminates RMDs completely.
3. Your plans for your estate
Although you can include the value of a ROTH IRA in your gross estate, because there are no RMDs, the account will grow larger than it would under a traditional IRA.
This means that ROTHs can leave money to heirs to withdraw income-tax-free over their lifetimes.
4. Do you have the cash on hand to pay the conversion tax?
It’s important to pay the conversion tax using outside funds, if possible. This is because keeping the ROTH balance higher offers greater potential advantage. If you do need to liquidate portfolio assets, you may want to consider using long-term capital gains assets that are taxed at a lower rate.
There are also a few other things you should think about when considering a ROTH conversion. First, because ROTH IRA withdrawals are tax-free, this may save some of your Social Security benefits from being taxed, and may even decrease your Medicare premiums.
If you do decide that a ROTH conversion is right for you, you may want to consider spreading the cost of the conversion over a few years. This will help you to manage your tax brackets, and gives you the ability to use outside funds to pay for the conversion tax.
Finally, consider the opportunity costs of using outside funds to pay the conversion tax. Keep in mind that money could have been invested all along, and what the taxes will be on money liquidated from your portfolio.
As you can see, a ROTH conversion can be a hugely beneficial tool, but can also be incredibly complex. If you’re interested in a ROTH conversion, we always offer a no-obligation meeting to review your financial situation, and figure out what the best strategy is for you. As we always say, there is no one-size-fits-all solution. You can schedule your no-obligation appointment by calling us at 216.520.1711, emailing us at Quarterback@Lineweaver.net, or clicking here.
Information contained herein is not tax advice and should not be considered as such. Each individual’s tax situation is unique and different. For advice related to your specific tax situation, please contact your personal tax professional.