Roth IRA Conversions

Roth IRA Conversions

Does it ever make sense to pay taxes sooner rather than later on retirement savings? As for a Roth Individual Retirement Account (Roth IRA), the answer might be yes. A Roth IRA is funded with dollars after-tax, and qualified withdrawals are completely tax-free. Also, Roth IRAs are not subject to the minimum required distributions (RMDs), which gives you greater control over your taxable retirement income.

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A Roth conversion of an existing retirement account is an important decision.

Among other factors, assessing your current income tax rate, your expected future income tax rate, and the anticipated rate of return on your investments.

As when making any decision on retirement planning, it helps to gather all your information in one place.

What Is a Roth Conversion?

A Roth conversion is an optional decision to change an existing qualified retirement plan into a Roth IRA, such as a 401(k) or a traditional IRA.

By doing so, you take money that is presently treated as tax-deferred and convert it into a tax-free account.

However, to do such a conversion, you must pay taxes on the amount you convert.

Converting a Traditional IRA into a Roth IRA

Converting all or part of a traditional IRA into a Roth IRA is a fairly simple process.

The IRS outlines three ways to get there:

  1. A rollover
    You take a distribution from your traditional IRA in the form of a check and deposit that money in a Roth account within 60 days.
  2. A trustee-to-trustee transfer
    You direct the financial institution that holds your traditional IRA to transfer the money to your Roth account at another financial institution.
  3. A same-trustee transfer
    You tell the financial institution that holds your traditional IRA to transfer the money into a Roth account at that same institution.

Of the three methods, the most foolproof are probably the two types of transfers.

If you take a rollover and, for some reason, do not deposit the money within the required 60 days, in addition to the other taxes you owe as a result of the conversion, you could be subject to a 10 percent penalty tax on early distributions.

The 10% penalty tax does not apply if you are 591⁄2 years of age.

Who Can Contribute To a Roth IRA?

If your modified adjusted gross income (MAGI) is equal to or higher than certain limits ($139,000 for single filers and $206,000 for married couples filing jointly in 2020), you can not contribute to a Roth IRA.

But there's a workaround: A Roth IRA conversion allows you to convert all or part of your existing traditional IRA funds to a Roth IRA, regardless of income level.

Why Now May Be The Ideal Time To Initiate a Roth IRA Conversion?

  • Low tax rates
  • Stock market decline
  • Reduced income could drop you into a lower tax bracket
  • A smaller tax bill for heirs

You don't pay taxes on the money you deposit with a traditional IRA, but withdrawals are taxed as ordinary revenues.

With a Roth, you deposit money that you have already paid taxes on, so the money that you withdraw when you retire is not taxable.

A Roth IRA conversion means that in the year that you move your money from the traditional retirement account to the Roth, you pay tax on your savings to establish tax-free income later in your life.

In the end, your Roth distributions will be a tax-free source of income from retirement.

If you convert to a Roth IRA in a year when you pay an unusually low rate of tax, you can avoid hitting higher taxes when you retire.

Converting To a Roth IRA Over Time

Many people are unable to afford to pay the taxes due on a potential Roth IRA conversion even though they believe that conversion is their best long-term strategy.

If that sounds like you, only the amount of your account you know you can afford to pay the tax comfortably can be converted.

You can continue to make a partial conversion year after year, never having to make that huge tax payment, but gradually convert your retirement accounts to a tax-free status.

The decision to convert to a Roth IRA need not be everything or nothing.

You may find the optimal solution for you is to divide your savings between a Roth and a traditional IRA or a Roth IRA, and a traditional 401(k).

Overall, converting to a Roth IRA could give you more flexibility in managing RMDs and potentially reduce your retirement tax bill, but be sure to consult our financial planner before moving on.

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Infinity Financial Network are not tax professionals. Please consult an appropriately licensed tax professional for all tax related matters.