If you have managed to save for retirement using a traditional IRA or 401(k), you may wish to consider doing a Roth IRA conversion. There are some good reasons for doing so, most of which include managing taxes. But should you go that route?
What’s a Roth IRA?
A Roth IRA is an individual retirement account where you contribute after-tax dollars. Additionally, you won’t have to pay taxes as your contributions and earnings grow. And finally, you can make tax-free withdrawals during retirement. The Roth IRA is an interesting financial tool that can work well for some people.
Who is eligible to contribute to a Roth IRA?
There are eligibility limits based on income. If you make too much money, direct investments into Roth IRAs are prohibited. However you still may be able to make contributions through a 401k plan assuming your employer has a Roth IRA option. However, most American families do qualify and it is an option if you want to have a tax-free savings and investment account. Plus, anyone at any age can contribute to a Roth IRA as long as you have earned income from a job.
Who do Roth IRAs benefit most?
Younger people in their 20s and 30s can benefit from Roth IRAs since they likely have many years for this investment to compound interest. That’s one angle of the benefits of Roth IRAs. But this is not to say that you’re out of luck if you are currently in your retirement years. Roth IRAs can work well for you during your post-work era as well. Here’s why:
When you established an IRA, you knew that someday you would have to fulfill required minimum distributions each year after reaching age 73. When you put the money in the IRA, it was tax-deferred, with taxes due on those required minimum distributions. You would pay the taxes on what you withdrew, or if your IRAs go to your kids someday, they would pay the taxes on withdrawals.
With an IRA conversion to a Roth, it’s different. You get the taxes out of the way upon establishing the new Roth IRA. There is no minimum distribution requirement. And when your heirs receive the money from this account, there will be no taxes due either. Under current rules, your heirs may stretch the distributions out over 10 years.
So, if you’re young, you should consider a Roth IRA as part of your portfolio. And if you’re older, converting IRAs to Roth IRAs may be a more ideal situation for your portfolio and its tax burden in the future.
What’s a Roth IRA conversion?
A Roth IRA conversion involves transferring retirement funds from a traditional IRA or 401(k) into a Roth account. The account holder must pay tax on the money they convert, but their withdrawals from the Roth account in the future will be tax-free. Now, let’s discuss when a Roth conversion a good idea.
Reasons Why You Should (or Should Not) Do a Conversion
Like other financial tools, whether or not to do a Roth IRA Conversion is dependent on your personal financial situation. Let’s look at some examples of when you might want to consider doing a Roth IRA conversion.
- Wealthy individuals in the highest, marginal tax brackets now and will likely be in this situation for the rest of their lives. Since it isn’t likely you will pay less taxes moving forward, a conversion now provides you a tax-free investment for the future.
- People who retire early and are in the lowest tax bracket. Their income is likely low, and they’re living off of after-tax accounts.
- An individual who believes taxes will increase in the future. In this case, you believe that your tax liability now is lower than in the future. The benefit is that you’ll start making tax-free money.
- Younger people who most likely will make increasing amounts of money as they get older. An added benefit is that they have many years for their investment to compound interest.
- A retired individual in a very high tax bracket with heirs also in a high tax bracket. It might make sense to do a conversion now, as you could save taxes for your whole family. Just make sure you consider the big picture of your financial situation before taking action.
If you don’t fall into one of those scenarios, then it’s important to take a look at your personal situation. You may consider a conversion if all of your money is currently in tax-deferred investments. Moving some of your investments into a Roth IRA would provide some money in an after-tax investment.
Is a Roth IRA conversion worth it?
If you’re considering a conversion and you’re not a financial expert, don’t take any action until you speak with a fiduciary. There are a lot of scammers out there touting Roth IRA conversions, but they only make the recommendation because it will provide a large commission from the sale of some investment or insurance product. Therefore, talk to a trusted advisor who will consider your personal situation and recommend a strategy in your best interest.
Contact me if you’d like to discuss your own, individual financial situation to see if a Roth IRA makes sense for you and for your family. The IRS has rules about Roth IRAs that are important to understand. I can help you explore all of the details of converting to a Roth IRA now, as part of your overall financial plan to help create a more comfortable retirement for you in the future.
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