Weekly Tax Advice: Should I convert my IRA to a Roth IRA?

Posted on March 6 2014

Since the introduction of the Roth IRA in 1997, many people have used it as an effective way to limit their tax liability in retirement. Traditional IRA accounts provide a tax deduction on contributions now, but all disbursements are taxed at that time. Roth IRA owners pay taxes on their income when they put it into the IRA, which increases tax liability now. However, all disbursements, including the earnings, are tax free, provided the owner sticks to the rules for withdrawing funds from the Roth IRA.

Prior to 2010, people with high income could not have a Roth IRA because they were not eligible to make contributions to the account. However, tax laws now allow anybody to convert a traditional IRA into a Roth IRA, regardless of income. The difficulty with the conversion is that you have to pay taxes now on the money you are converting that was claimed as a tax deduction when you initially contributed it to the IRA. Adding the money you are converting into a Roth IRA to your current year's income is likely to result in a very large tax bill. Therefore, consider several questions when determining whether you should convert your IRA to a Roth IRA.

Do you still have many working years ahead of you?

The people who are likely to benefit most from a Roth IRA conversion are those who plan to stay in the workforce for many years to come. This is because the main benefit of the Roth IRA is that not only do you get to withdraw your initial contributions in retirement without paying taxes on them, but all of the earnings are completely tax free. This is in contrast to the traditional IRA, where the earnings are just tax deferred. The longer you have until retirement, the more your earnings will get to grow without having to pay taxes on any of them.

Do you expect to be paying a similar tax rate when taking withdrawals as you are now?

Your marginal tax rate will play into the calculations of whether you should go through with a Roth IRA conversion. If you convert, you will have to pay taxes on the amount of the conversion in your current highest tax bracket, which may be even higher than usual if you are converting a large amount. In contrast, if you don't convert, you will be paying taxes later on the income in the tax bracket you will be in during retirement. If you expect to have a low income during retirement, your deductions and exemptions could wipe out much of your tax liability and it wouldn't make sense for you to pay taxes on the money now. However, if you expect to be in a similar or higher tax bracket during retirement, paying taxes on the balance now can help you avoid paying even more taxes on the account's balance and earnings later.

Do you have funds available to pay the tax bill?

You must pay taxes on the amount you converted to a Roth IRA last year on your tax return with OnePriceTaxes this year. Depending on the size of your account, this could be a huge tax bill. You will need to have money available to pay your taxes now, or you must be willing to withdraw money from your IRA (and pay any relevant penalties) to cover the cost of the conversion. If the size of the tax bill is a deterrent, you can convert part of the IRA each year and count as income only the amount that you convert. If you take this approach, you must wait at least one year between conversions. Also keep in mind that your earnings will not be growing tax-free until the money is in the Roth IRA, so it is to your advantage to convert it as soon as possible.

Do you want to avoid the required distributions at age 70 1/2?

One of the key differences between a traditional IRA and a Roth IRA is that you must begin taking distributions from a traditional account when you reach age 70 1/2, regardless of whether you need the distributions as income then or not. If you have many other types of retirement assets you plan to use first or you expect to keep working past age 70 1/2, a Roth IRA could be much better for you. This account never requires you to begin taking distributions, so you are in control of how much money to withdraw and when.

Do you plan to use the IRA to pass along money to your heirs?

The other major advantage of a Roth IRA is that you can allow your heirs to withdraw money from the account tax-free after your death. Although the IRA will be included in the calculations of the estate taxes, the withdrawals will not be taxed, provided the contributions were made at least five years ago. This can help more of your money make it to your heirs, especially because they may be required to take disbursements from the account while they are in a high tax bracket.

Determining the best course of action for your situation

Now that you understand the tax implications of a Roth IRA conversion, you should be able to determine what route is best for you. Many people will find that there is an obvious answer to the question of whether a conversion is a smart financial move. However, some people will find that they will reap some benefits of making the conversion, but also suffer a few consequences. In this situation, take the time to talk over the dilemma with one or more trusted financial advisors who can help you make the best choice for your current and future financial situation. If you decide to go ahead with the conversion, OnePriceTaxes will easily help you understand and pay your tax bill.

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