Should you switch to a Roth Individual Retirement Account (IRA)?

Should you switch to a Roth Individual Retirement Account (IRA)?

Your age could play a role in your decision about whether or not to convert

You might have given some thought to switching to a Roth individual retirement account (IRA) if you already have a regular individual retirement account (IRA). With the help of a conversion, investors are able to move money out of a traditional IRA, pay taxes on the funds at the standard federal and state rates, and then move the money into a Roth IRA, where it will continue to grow tax-free. As long as you complete the requirements for a Roth IRA, any money you take out of the account in the future won’t be subject to taxes. 

To be eligible for tax-free distributions from a Roth IRA, you must wait until you have participated in the plan for a total of five taxable years and be 59 1/2 years old or older when you take the money out of the account. In the event of a conversion, it must have been a full five years since the conversion took place. 

Converting traditional IRA funds to Roth IRA money might make a lot of sense for certain people. On the other hand, there are some circumstances in which it absolutely does not make any sense. Ask yourself the following things before you convert your existing account to a Roth IRA:

Key Takeaways

When you move money from a traditional retirement account, such as a traditional IRA, pension, or defined contribution retirement account, into a Roth account, this is referred to as a Roth conversion.

Converting your traditional IRA into a Roth IRA isn’t going to make much sense if you’re going to be retiring in less than five years.

You have to be ready and able to pay the extra taxes that come with switching to a Roth IRA.

If you believe that you will be in a lower tax bracket when you retire compared to where you are now, converting your 401(k) to a Roth IRA could be a financial decision that is not in your best interest.

Are You Getting Close to Retirement and Need Income from Your IRA?

It is not a good idea to convert your traditional IRA to a Roth IRA if you are getting close to retirement or if you need the money in your IRA to support yourself. The conversion to a Roth IRA will cost you money since you will be required to pay taxes on the cash you transfer over. 

The money you spend upfront won’t be justified by the money you save on taxes for a set number of years. Increasing the amount of money you take out of retirement will push back the target date. A Roth conversion calculator is a helpful tool that can help you figure out if making the switch would be good for you.

The fact that the assumptions behind a Roth IRA conversion calculator are dependent on future income tax projections presents a hurdle for those who rely primarily on such a tool. It is impossible to make an accurate forecast regarding the progression of income tax rates over the next one to two years. 

Consider how difficult it could be to estimate the tax rates that will be in effect 10, 20 or even 30 years from now when you will be withdrawing money from your Roth IRA.

Before you convert a regular IRA into a Roth IRA, you need to make sure that you have analyzed both your current and expected tax brackets. The next step is to make a plan for your retirement budget so you can figure out what your future tax bracket will be based on how much money you expect to get.

You may figure out which marginal tax bracket you fall into by consulting either our Federal Income Tax Table Guide or the information from your most recent tax return.

Are You Going to Be Able to Pay the Taxes?

Because you will be required to pay taxes on your existing IRA, converting it to a Roth IRA might be an expensive financial decision. In an ideal world, you wouldn’t have to take the money out of your savings for retirement. 

If you have to withdraw money from your conventional IRA in order to pay your taxes, converting that money to a Roth IRA will cost you money, so it is wiser to just leave the money in the traditional account. 

The cost of conversion can be spread out over a number of years, which is one strategy that should be considered. This may also prevent you from moving up into a higher tax bracket than you would have otherwise been in.

Would You Like to Make Your Tax Payments?

It’s not always easy to figure out what the best course of action is for one’s finances. When contemplating a conversion to a Roth IRA, a good number of owners of regular IRAs experience this sentiment. 

Do you think it’s possible for someone to have $300,000 saved in an IRA and then immediately decide to give away $75,000 of it? Converting your traditional IRA into a Roth IRA might seem like an attractive option on paper, but in practice, it could be more difficult.

You might be able to make up for the taxes you have to pay when you switch to a Roth IRA by giving money to charity.

Deductions from taxable income are one tactic that could be useful in mitigating the financial impact of converting a traditional IRA into a Roth IRA. To use this method, you will first need the money and the desire to give to a charity.

In the Future, Do You See Yourself Being in a Lower Tax Bracket?

It does not make financial sense to convert if you believe that you will spend your retirement years in a lower income tax bracket than the one you are in today. If you convert your traditional IRA into a Roth IRA, you will have to pay higher taxes than you would if you took the money out of your standard IRA when you retired.

Some people who invest in IRAs can benefit from converting their traditional IRAs into Roth IRAs. Before you take any steps to convert your money, it is important to give careful consideration to the prospective conversion.

Questions That Are Typically Asked (FAQs)

How much tax do you owe if you convert your traditional IRA to a Roth IRA?

Any money you take out of a traditional Individual Retirement Account (IRA), 401(k), or any other account to which you made tax-deductible contributions will be taxed at the same rate as your regular income.

A conversion might not be worth it if you anticipate being in a lower tax band when you retire compared to what you are currently in.

When do I have to make the tax payment on my conversion to a Roth IRA?

When you file your taxes for the year in which you converted to a Roth IRA, you will be required to pay taxes on the amount that you converted. Therefore, if you convert your 401(k) or IRA to a Roth IRA in 2021, you won’t have to pay taxes on the earnings until April 2022, when you file your tax return for 2021.

What tax form would I receive if I converted my current retirement account to a Roth IRA?

Along with Form 5498, which details the contributions you made to your Roth IRA, you should also receive Form 1099-R, which details the dividends you received from your Roth IRA during the previous year.

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