Individual Retirement Accounts or IRAs are a popular investment tool for retirement. They offer tax advantages, flexibility, and control over one’s finances. Two types of IRA accounts exist- Traditional IRA and Roth IRA.
Traditional IRA contributions are tax-deductible in the year they were made; however, withdrawals during retirement are taxed at the ordinary income rate. On the other hand, contributions to a Roth IRA account have already been taxed upfront; thus, withdrawals during retirement are tax-free.
Many people wonder if it makes sense to convert their Traditional IRA into a Roth IRA. While conversion may not make sense for everyone in every situation, it is worth considering if you meet specific criteria.
What is Conversion from Traditional to Roth IRA?
A conversion occurs when an investor transfers funds from their Traditional IRA to a Roth account. The process involves paying taxes on any pre-tax dollars transferred and moving them into an after-tax account with potential future tax-free growth.
For instance, suppose an investor has $100k in their traditional account that was initially funded using pre-tax dollars and decides to convert these funds into a Roth account. In that case, they will owe taxes on the entire amount as though it were regular income received that year. After paying the taxes owed on this amount out of pocket (or by taking some money out of the converted balance), they will then transfer the remaining balance ($100k minus taxes) into their new Roth account.
Reasons Why Investors Convert
1) Change in Tax Rates
If an individual anticipates being in higher marginal tax rates during retirement than at present time due to changes like increased earnings or reduced deductions during retirement years – converting could be beneficial since all future gains would be free from federal income taxation.
2) Estate Planning
Roth IRAs don’t require minimum distributions (RMDs). This means individuals can leave assets untouched until death without facing penalties or mandatory withdrawals like traditional IRAs do once owners reach the age of 72. By converting an existing Traditional IRA to a Roth account, individuals can pass assets onto heirs tax-free.
3) Diversification
Investors who have primarily invested in traditional IRAs may wish to convert some funds into a Roth account for diversification purposes. This allows investors greater flexibility when it comes to managing their retirement income stream since they can choose which accounts/assets to draw from based on tax efficiency or other factors.
4) Eligibility for Roth Contributions
Some high-income earners are not eligible to contribute directly into a Roth IRA due to IRS rules. However, they can fund their traditional IRA and then convert it into a Roth account since there are no income restrictions on conversions.
5) Future Tax Laws Uncertainty
Suppose an individual believes that future federal income tax rates will rise significantly, making the conversion more appealing since all future earnings would be free from this new taxation.
How To Convert From Traditional To Roth IRA?
Converting your Traditional IRA to a Roth account is relatively simple and easy. Here’s how you can do it:
1) Open A New Account – If you don’t already have one, open up a new Roth IRA with your financial institution/brokerage firm.
2) Initiate The Conversion – Notify your current provider about moving money from your traditional account to the new one via conversion so that they issue necessary forms and help make sure everything is done correctly.
3) Pay Taxes Owed- After calculating how much taxes you owe (based on your total pre-tax contributions), pay them using after-tax dollars either out-of-pocket or by taking some of the converted balance.
4) Transfer Funds – Once taxes owed are settled-upon; transfer money over from the old plan’s custodian (financial institution holding funds).
Important Things To Remember When Converting From Traditional To A Roth Account:
1) Taxes Will Be Due- Investors must pay taxes upfront when converting funds from a Traditional IRA to a Roth account since the money within the traditional account was funded with pre-tax dollars.
2) Required Minimum Distributions (RMDs)- If you’re over 72 years old, make sure to take your RMD before converting any assets from your traditional IRA into a Roth account since they don’t require distributions.
3) Timing Matters- Converting at the end of the year when knowing your total income can help minimize taxes owed as it allows for more accurate calculations on additional taxable income.
4) Recharacterization is possible- In some cases, investors may want to undo their conversion due to unforeseen circumstances. Investors have until October 15th of the following tax year to recharacterize an earlier conversion if desired.
Conclusion
Converting from Traditional IRAs to Roth accounts can provide substantial benefits for many investors. However, it’s essential first to consider factors such as current and future tax rates, diversification needs or estate planning goals before deciding whether this move makes sense for you. Be sure also not only consult with financial advisors but also speak with knowledgeable tax professionals who are familiar with these types of conversions so that all aspects including any potential penalties or other considerations are clarified upfront.