Families and individuals seeking possible solutions to lower federal taxes during retirement should take a close look at the pros and cons of converting funds from their traditional individual retirement (IRA) account to a Roth IRA.
The process, commonly referred to as a Roth conversion, involves transferring part or all the funds from a traditional IRA to a Roth IRA. The procedure itself is easy to do; the factors that go into deciding to convert the funds, however, are complicated. Each family or individual’s situation, including tax bracket and current and future income needs, must be analyzed to see if it makes financial sense. A Roth conversion is also permanent, so there is no option to transfer converted funds back into your traditional IRA.
The primary benefits of a Roth conversion center on how withdrawals are treated during retirement. In general, those benefits include:
• Tax-free withdrawals: After the minimum age of 59 1/2, all withdrawals from your Roth are tax-free because you already paid taxes on your contributions. In contrast, you must pay taxes on traditional IRA withdrawals because all contributions to the account were made with pre-tax dollars, and the IRS treats those withdrawals as ordinary income.
• No required minimum distributions: One of the advantages of a Roth IRA is that you do not have to take annual required minimum distributions (RMDs) from the account. With a traditional IRA, you are required (with a few exceptions) to begin withdrawing funds every year after you reach the age of 72, and you must pay income taxes on those withdrawals.
When talking about a Roth conversion with your financial advisor, one of the most important questions to answer is this: When will you need the funds? It is to your advantage to let Roth funds appreciate in value and generate income as long as possible because the Roth grows tax-free. If you are near or at retirement age and will be using the money to enjoy this stage of your life, then a conversion may not make sense. That is because you need several years for the Roth funds to increase to make the payment of tax worth converting, considering your tax bracket at the time of conversion.
One final “bonus” of having a Roth: If you do not use your Roth during your lifetime, a Roth conversion can be a smart estate planning strategy to pass down tax-free wealth to your loved ones. Beneficiaries will have to take RMDs, but those withdrawals remain tax-free if the account has been open for at least five years.
A Roth IRA can be an invaluable wealth management tool because the funds grow (and compound) tax-free, and withdrawals from the account are also free of federal income tax. But before you take any action, please seek counsel from an experienced financial advisor and tax professional to make sure you reach a decision that will help you protect and grow your wealth and provide for your loved ones.