How much you pay in taxes now can have a huge impact on how much money you have to retire with in the future. One way that people can minimize how much they pay in taxes is with a Roth IRA. These are accounts where you contribute money that’s already been taxed and later have the ability to withdraw earnings tax-free when you’re retired. Traditional IRAs, on the other hand, require that you pay taxes when you withdraw from the account in retirement.
Many investors and high-income earners aren’t eligible to set up a Roth IRA. However, there is a backdoor way to tap into the benefits of this type of retirement account. For this reason, it’s quite common for investors to do what is known as a Roth IRA conversion.
What is a Roth IRA conversion, exactly, and what are the advantages and disadvantages of this strategy?
Let’s take a deep dive into everything you need to know to help you make the right decision for your financial health.
What Is a Roth IRA Conversion?
Before we get into the advantages and disadvantages of a Roth IRA conversion, let’s take a look at what exactly the term means. Basically, this conversion occurs when you take funds from one of three types of IRAs and put them into a Roth IRA. The three types of IRAs are:
- Traditional IRA
- Savings incentive match for employees (SIMPLE) IRA
- Simplified employee pension (SEP) IRA
Individuals are only typically allowed to invest in a Roth IRA if their MAGI (or modified adjusted gross income) is less than a certain number set by the government. This means that if you’re married and filing your taxes jointly, your combined MAGI must be below a certain limit in order to invest in a Roth IRA.
However, investors have been allowed to move their funds from traditional IRAs to Roth IRAs starting in 2010. This is the case no matter how high their income is.
So basically your income has to be below a certain limit in order to invest in a Roth IRA, but there aren’t any income limits to convert funds from a traditional IRA to a Roth IRA.
This might sound like a no-brainer to the financially savvy. However, there are two sides to the coin with advantages and disadvantages.
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What Are the Advantages of a Roth IRA Conversion?
There are a lot of reasons a Roth IRA conversion might be a good choice for your financial health. Let’s take a look at the advantages of a Roth IRA conversion.
Your Earnings and Contributions Can Grow Tax-Free
Roth IRAs don’t give you an upfront tax break. However, both your earnings and your contributions can grow tax free in this type of retirement fund.
What this means is that you are done paying taxes on the money in your Roth IRA after paying taxes during the conversion. That is, so long as you take a qualified distribution.
If you anticipate that you will continue making more money in the future and therefore be in a higher tax bracket, this can mean a lot of savings.
You Aren’t Required to Take Minimum Distributions
Another perk of Roth IRA conversions is that you aren’t required to take the required minimum distributions at the age of 72. This means that you can leave the money intact and leave it for your heirs to inherit if you don’t need the money for yourself at the time.
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You Can Withdraw Contributions Tax-Free at Any Time
Another big perk is that you can withdraw contributions tax-free, at any time, for any reason. It should be noted, though, that the same isn’t true of earnings. There’s also a caveat you should know about when it comes to conversions, which we’ll discuss later on in the article.
That being said, it isn’t considered good financial practice to treat your Roth IRA as if it were a bank account. Even though you can withdraw contributions at any time without tax implications, that doesn’t mean you should. Withdrawing money now means that it won’t have the opportunity to grow, which can make a big difference for your financial health in the future.
It Allows Access to Roth IRAs for Those Not Normally Eligible
Another more obvious benefit of Roth IRA conversions is that those who are not normally eligible can benefit from this type of retirement fund through a conversion. For high earners, this can be a smart move if they anticipate that their tax rate will increase in the future.
What Are the Disadvantages of a Roth IRA Conversion?
On the other hand, there are definitely some risks and downsides to a Roth IRA conversion. Let’s take a look at the cons of going this route.
Taxes Are Paid at the Time of Conversion
On the top of our list of disadvantages of a Roth IRA conversion is the taxes you will pay at the time of the conversion. For example, if your effective tax rate is 24% and you are converting $100,000 from a traditional IRA to a Roth IRA, you’ll need to write a check for $24,000.
Additionally, you can even move up into a higher tax bracket if you are converting a large enough sum of money.
There Is a Waiting Period for Taking Penalty-Free Withdrawals
For younger people, there is another drawback. Funds must be kept in the new Roth IRA account for five years. On top of that, there are penalties for taking out money before you’ve reached the age of 59.5. If you do take out money before you’ve reached this age, you’ll have to pay a 10% early distribution penalty and pay taxes on any earnings.
A Roth IRA Conversion Can Make Taxes More Complicated
If you have other traditional IRA, SIMPLE IRA, or SEP-IRA balances in addition to converting a Roth IRA, it can make taxes really complicated. Basically, you have to run some pretty complex calculations regarding the money that has already been taxed and the money that hasn’t yet been taxed.
The percentage that results from this calculation is considered income that is taxable. It really is quite complicated, and will likely require the help of a tax professional unless you are one yourself.
It Might Not Be Beneficial If You Anticipate a Lower Tax Rate in the Future
A risk that you run when you do a Roth IRA conversion is that you might be in a lower tax bracket later. If that ends up being the case, you’ll likely kick yourself for writing such a whopping check to the IRS.
At the end of the day, you simply can’t know what will happen in the future. Both your income and future tax rates are difficult to anticipate, though you can do your best to make an educated guess.
When Do You Pay Taxes on a Roth IRA Conversion?
If you are using a Roth IRA conversion as one of your financing strategies, it’s important to understand how and when you’ll pay your tax bill.
Many individuals assume that they will pay these tax bills when they file their taxes. Actually, though, you need to pay this bill before you file your taxes. There can be hefty penalties if you don’t send the check in for your estimated quarterly taxes.
It is advised that you use funds from a different account to pay this tax bill. You might choose to cash out a matured certificate of deposit (CD) or take money from your savings account. It isn’t ideal to take money from the IRA that you’re converting into a Roth IRA.
The reason for this is that your future earning power will be eroded by paying taxes from the retirement investment fund. Because of the power of compounding interest, this can mean losing out on a lot of interest earned in future years.
ROTH IRA Conversion: Is It Right for You?
As you can see, there are some seriously compelling pros and some pretty concerning cons when it comes to whether or not a Roth IRA conversion is a good idea. Depending on where you are on the road to retirement, this strategy may or may not make sense for you.
When used correctly, a Roth IRA conversion can help you maximize the amount of money you have in retirement. If you expect to earn more money in the future so that you move into a higher tax bracket or if your taxes rise because of tax rate increases, a Roth IRA conversion can seriously save you money over the years.
That being said, there are some real risks and drawbacks to this financial strategy as well. It can be difficult to calculate the tax bill that is due at the time of conversion, and the resulting number might make your jaw drop. Making a decision of this magnitude likely requires consultation with a tax professional.
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