What is a Roth IRA Conversion?
A Roth IRA conversion is a tool that allows individuals to convert money from a tax-deferred retirement account like a traditional IRA or 401k into a Roth IRA.
Roth IRAs aren’t tax-deferred like many other retirement accounts, meaning the money you contribute is after-tax income. But if you’re converting money that’s already in another retirement account, then you’ve likely already taken a tax deduction for it. As a result, Roth IRA conversions are considered taxable income, and you’ll have to pay income taxes on the full amount you convert from a traditional IRA.
Who Should Do a Roth IRA Conversion?
The key benefit of a Roth IRA is that you contribute after-tax dollars, but then can withdraw your earnings during retirement. Because a Roth IRA grows tax-free, a Roth conversion might be the right choice for anyone who expects to pay a higher tax rate during retirement.
There are plenty of reasons why someone might pay a higher tax rate during retirement, even though it seems that wouldn’t be the case.
If you’re early in your career, then your current tax rate could be the lowest you’ll pay moving forward. This could also be the case for young families with lots of deductions to take advantage of.
Another great time to do Roth conversions would be in a year when your income is relatively low for some reason, such as taking time off work for a sabbatical, mini-retirement, or return to school. Additionally, it may be useful if you lose employment, like the millions of people who lost their jobs in 2020.
A backdoor Roth IRA is also a good reason to perform a Roth conversion. One of the downsides of a Roth IRA is its income eligibility restrictions. Only individuals with an income of $140,000 or less and married couples with an income of $208,000 or less can contribute in 2021. Utilizing backdoor Roth IRA conversions, you can get around the income restriction so that even high-earning individuals and couples can contribute to a Roth IRA.
Ultimately, a Roth conversion can provide peace of mind knowing that your retirement savings will be going directly into your pocket during your later years rather than toward taxes.
A Roth IRA conversion is also beneficial if you plan to delay IRA distributions. In the case of a traditional IRA, you must take required minimum distributions (RMDs) beginning at age 72. A Roth IRA has no such requirement, making it an excellent tool for any money you plan to leave to your heirs or use in your later years.
Who Shouldn’t Do a Roth IRA Conversion?
While a Roth IRA conversion can be a great tool for many individuals, it’s not the right move for everyone.
The benefit of the Roth IRA is that it allows you to pay the tax bill on your contributions now, but then withdraw your earnings tax-free during retirement. But for those in a higher tax bracket, it’s entirely possible that their tax rate during retirement will be considerably lower than it is today. In that case, it might be beneficial to pay the tax bill during retirement when the rate is lower.
Another consideration with Roth IRA conversions is that the amount you convert from a traditional IRA counts as taxable income in the current tax year. First, this could result in a hefty tax bill that’s more than you have on hand. And in some cases, it could bump you into a higher tax bracket, resulting in a larger bill than you were expecting.
If you aren’t sure whether a Roth IRA conversion is right for you, consult a tax professional for guidance.
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