Unlocking the Benefits of Roth Conversions
When you first began saving for retirement, you may have opted for a traditional retirement account to obtain immediate tax benefits. As your financial situation evolves, you might be wondering if converting funds to a Roth IRA makes sense. A Roth conversion involves moving funds from a traditional IRA to a Roth IRA, potentially providing you with tax-free retirement income.
What is a Roth conversion?
A Roth Conversion refers to the act of transferring funds from a tax-deferred retirement account into a Roth IRA. Unlike traditional IRAs and 401(k)s, Roth IRAs offer tax-free withdrawals in retirement, which can be a game changer for your financial future.
What are the benefits?
Tax Diversification:
One of the most significant advantages of Roth conversions is tax diversification. By having a mix of taxable, tax-deferred, and tax-free retirement accounts, you can strategically withdraw funds in retirement to minimize your tax burden. This flexibility can help you optimize your retirement income.
Tax-Free Withdrawals:
Perhaps the most compelling benefit of Roth conversions is the ability to enjoy tax-free withdrawals in retirement. Since you've already paid taxes on the converted amount, you won't owe any additional taxes when you take money out of your Roth IRA after age 59½, provided you've held the account for at least five years.
No Required Minimum Distributions (RMDs):
Roth IRAs do not have RMDs during your lifetime, unlike traditional retirement accounts. This means you can leave your money to grow tax-free for as long as you wish, allowing for potential intergenerational wealth transfer.
Estate Planning:
Roth IRAs can be a powerful tool for estate planning. Your heirs can inherit a Roth IRA tax-free and continue the tax-free growth over their lifetimes, as long as they follow IRS rules.
Hedge Against Future Tax Increases:
With discussions about potential tax increases, having a source of tax-free income in retirement can provide a hedge against higher tax rates in the future.
What should I consider before making a Roth conversion?
When do you plan to retire?
If you plan to retire within a few years, a Roth conversion may not be the best choice due to the required five-year holding period for converted funds. Early withdrawals can result in penalties and taxes.
What is the tax impact?
Remember that a Roth conversion triggers immediate tax consequences. You must pay taxes on the converted amount in the year of the conversion, which could potentially push you into a higher tax bracket. Using the converted funds to cover these taxes is typically discouraged to avoid depleting your retirement income.
What will your tax bracket be in the future?
Consider whether your future tax bracket will be higher or lower during retirement. If you anticipate being in a lower tax bracket later on, delaying the conversion might be advantageous. However, if you are currently in a lower tax bracket due to a temporary income reduction, a conversion now could be beneficial.
How to implement Roth conversions with your current tax strategy.
To manage your tax liability effectively, think about converting a portion of your traditional IRA into a Roth IRA over several years rather than doing a lump-sum conversion. This can help you stay within a lower tax bracket.
The ability to withdraw tax-free income in retirement is appealing to many. Although you may have chosen a tax-deferred account years ago, you still have the option to convert it at any time. Before making any changes, make sure to speak with your financial advisor.
Need help determining if Roth conversions would benefit your financial plan? We’d love to help. You can contact us here or schedule a call with Evan today.
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