4 Things To Consider When Converting IRAs to Roth IRAs

For most people planning their retirement, the main question to ponder over is where to invest their savings such that they can live comfortably during their retirement years. While picking an individual retirement account (IRA) is a step in the right direction, there is more to be planned to ensure financial security in retirement. An important factor to take into consideration while saving for retirement is minimizing your tax liabilities, as it ensures that you are making the most of your retirement investments. One way you can do this is by converting your IRA to a Roth IRA.

Conversion of an IRA to a Roth IRA

One can make direct investments into a Roth IRA only up to a certain income level. Thus, if you want to reap tax benefits, the chances of that are lower unless you plan on using a conversion strategy. Simply put, under a Roth IRA conversion, you’d be transferring your retirement savings from a traditional IRA to a Roth IRA to derive future tax benefits. If you have a Roth IRA, you can make tax-free withdrawals at retirement and enjoy tax-free growth on your investments. While conversely, in a traditional IRA, your money grows tax-free, and you have to pay a charge when withdrawing your funds. Do note that converting a traditional IRA to a Roth IRA will attract taxes as well, but the amount that you’ll be required to pay at the time of conversion will be far lower than future tax rates. We advise that you make this call after conducting an exhaustive analysis of your present and future incomes.

Let’s talk about certain considerations one needs to take into account when converting an IRA to a Roth IRA:

Analyze your current and future tax bracket to reap higher tax benefits

The prime benefit of converting an IRA to a Roth IRA is to take advantage of tax benefits, as future tax rates are likely to be on the higher side compared to the present tax rates. Thus, it is important that you conduct a thorough analysis of your current and future tax bracket and only go forward with the conversion if the predicted tax bracket is expected to be higher than the present one. The next thing that you should be tackling is a retirement budget. You can take the help of a financial advisor to guide you through the process and create a retirement income plan for you that can help predict your future tax liability.

Moreover, since the conversion entails costs that need to be paid in the present, you should have your finances to be able to pay the transfer taxes that you would accrue at the time of conversion. Ideally, these taxes should be paid from sources other than a traditional IRA. If you use your IRA funds to pay for Roth IRA conversion fees, it can make a big dent in your retirement holdings. Furthermore, if you make any withdrawals from an IRA before reaching 59.5 years of age, you will attract a penalty of 10 percent. Thus, it is in your best interests to not convert your IRA to a Roth IRA in case of insufficiency of non-IRA funds for payment of conversion costs.

You should also make a note that in a Roth IRA, after-tax investments are included and tax-free growth along with untaxed withdrawals are permitted, provided the distributions are qualified. Distribution is deemed as qualified if it occurs after at least five years from the year of conversion (including the year in which the conversion took place). There are other instances as well where distributions are said to be qualified, such as:

• Occurring on or after reaching 59.5 years of age
• On or post an employee’s death
• In case an employee suffers from a disability

Therefore, to derive benefits from a Roth IRA conversion, the investments should be qualified in nature.

2. Be careful about the timing of your conversion of an IRA to a Roth IRA

One important consideration to keep in mind at the time of converting an IRA into a Roth IRA is the timing of the conversion. Say, for instance, if you wish to withdraw your savings within five years of the conversion, you’d be liable to pay a penalty of 10 percent as well as conversion taxes. Thus, you should only plan for a withdrawal after five years has passed. In addition, the rollover approach works best when the balance in your IRA is considerably less due to market lows. This is helpful because you are then obligated to pay conversion taxes at a lower tax conversion rate that results in more savings for you.

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3. Carry out the conversion from an IRA to a Roth IRA in a phased manner

If you're thinking about transferring your retirement savings from an IRA account to a Roth IRA, it is important to do so in a phased manner rather than carrying out a wholesale conversion. A lump sum amount is at an increased risk of attracting higher taxes. For instance, if a married couple having a joint taxable income of $115,000 decides to switch to a Roth IRA, it would be ideal for them to convert the account money only up to $50,000 or less to a Roth IRA. This would mean that the transferred money falls under a tax bracket of 22 percent, applicable to incomes between $78,951 – $168,400. However, if one goes even a few dollars beyond that, the tax levied would change to 24 percent, a higher tax bracket, leading you to pay more taxes. Hence, it would be wise if one spread the conversions over several years and carried them out partially to save on taxes.

4. Be clear about the commingled money

A common issue faced by investors when thinking about converting their IRAs to a Roth IRA is what to do with the commingled money (monies saved under different plans within a single IRA that includes both deductible and non-deductible money). Before you proceed with the conversion, you have to find out how much of the convertible money is taxable. Say, for instance, if you have only deductible contributions in the IRA, then the taxes owed on the money, contributions, and earnings will amount to the same while converting your IRA into a Roth IRA. On the other hand, if you have both deductible and nondeductible contributions, the value of taxes owed in that case would change. Hence, it is important to know the taxable amount owed by you in a traditional IRA at the time of conversion.

If a person switches their job and merges different retirement plans such as a 401(k), or a 403 (b), etc. to an existing IRA instead of a new one, then the accumulation of commingled money can take place. In addition, it can also accrue if an employee makes voluntary retirement savings without being a part of any employer retirement plan. The IRA does not collect tax on these savings which makes them liable to be charged for tax at the time of converting these accounts to a Roth IRA account.

To summarize

The process of converting an IRA account to a Roth IRA enables an investor to derive tax benefits in the future but at an immediate tax cost. It is a good option for a person looking to make tax-free earnings, have a lower taxable income in retirement, or looking for minimum distributions from a traditional IRA. Converting your traditional IRA account to a Roth IRA offers several benefits; however one needs to exercise this strategy with caution and preferably after seeking advice from an experienced financial advisor to maximize the benefits of conversion.