5 Essential Things To Know About Roth Conversions

Individual Retirement Accounts (IRAs) are great financial instruments that allow people to funnel their funds into their retirement savings. These accounts offer important tax advantages - investors having traditional IRAs can benefit from tax-deferred savings whereas those having Roth IRAs can take advantage of tax-free income.

Simply put, an individual who has invested in a traditional IRA can use his pre-tax income towards investments that grow tax-deferred till the time of their withdrawal during retirement. Alternatively, an individual who has invested in a Roth IRA can make qualified withdrawals on a tax-free basis provided he meets certain predetermined conditions. It should be noted that contributions made to a Roth IRA are not tax-deductible.

It is a tricky decision to make when it comes to choosing between sticking with a traditional IRA or going for Roth IRA conversion. To make an informed decision, you need to understand how a Roth conversion works and the implications on social security taxation. Consulting a professional financial advisor can help you clear up your doubts about Roth IRA conversion and understand the effect on your present and future tax situation.

What is a Roth IRA conversion?

Typically speaking, a Roth IRA conversion refers to a taxable transfer of funds from either a traditional IRA, Simplified Employee Pension (SEP), or SIMPLE IRA, to a Roth IRA. This transfer allows you to move your funds from a pretax traditional IRA to a post-tax Roth IRA enabling you to grow your after-tax money and making it tax-free at the time of withdrawal.

Roth IRA contributions are considered to be made with after-tax dollars, allowing you to make tax-free withdrawals during retirement. In addition, you are not required to pay any taxes on any earnings if you make a withdrawal, provided you have held your Roth IRA account for at least 5 years and are 59.5 years of age or older.

Any citizen of the United States is eligible to convert their traditional IRA into a Roth IRA. However, that was not the case before, with several restrictions placed on Roth IRA conversions that deterred people from going ahead with the conversion. Since the beginning of 2010, most of these restrictions were removed, so income limits and tax filing status are no longer necessary if you are applying for a Roth conversion.

Should one consider a Roth conversion?

There are quite a few benefits when it comes to a Roth conversion. If you expect your tax bracket to go up in retirement, it would make sense to pay taxes at the present at a lower rate compared to the higher rates once you have retired. Also, if you have generated a substantial amount of savings in your retirement accounts, you should consider converting at least some part of the funds, if not all, into a Roth IRA.

In addition, if you do not have a lot of tax diversification in your retirement accounts (i.e. the majority of your wealth and other assets are kept in tax-deferred accounts), it would be prudent to consider a Roth conversion for tax purposes, since your assets won't be taxable at the time of making withdrawals during retirement.

5 essential things you must know about Roth conversions

If you own a traditional IRA account, considering a Roth IRA conversion can be a wise decision if you wish to make tax-free income a reality for yourself. However, before you take this step, there are certain things that must be brought to your attention:

  1. You can either opt for a full conversion or a partial conversion of Roth IRA
  2. When converting a traditional IRA to a Roth IRA, you have the option of either converting all your funds or only some portion of them. The funds that you do end up converting are taxed at the same rate as ordinary income. You may consider going for martial conversion of funds to a Roth IRA, as, by doing so, you may avoid being put into a higher tax bracket.

  3. You are liable to pay taxes when making a Roth conversion
  4. At the time of making your IRA contributions, if you have received any tax deductions, you’d be liable to pay taxes on it at the time of making a Roth conversion. The exact amount that needs to be paid can differ from person to person and can be verified through the Internal Revenue System (IRS) Form 8606. You may also need to pay additional state taxes depending on the state that you reside in. Do remember that if you happen to make any distributions of converted funds before the completion of a 5 year period following the conversion, you would attract a tax penalty of 10 percent if you are under 59.5 years of age.

  5. You can control your Medicare costs through a Roth IRA
  6. The premiums paid towards Medicare Part B are based upon the total taxable income of the individual in retirement due to which it can be a bit tricky. Why you may ask? Well, if your income goes up by even a single dollar, you may have to pay hundreds of extra dollars when it comes to your Medicare B premiums. You can circumvent this scenario by investing in a Roth IRA that will allow you to make a completely tax-free income in retirement.

  7. Your heirs may benefit from a Roth conversion too
  8. One of the major benefits when it comes to Roth IRAs is that they do not have any minimum distribution requirements which is not the case with a traditional IRA. If you do not foresee yourself withdrawing funds from your IRA, you may opt for converting to a Roth IRA. This will allow your funds to grow tax-free undiminished by Required Minimum Distributions (RMDs). By doing this, you will be able to leave a more sizable inheritance for your heirs, who can take advantage of tax-free withdrawals after meeting certain requirements.

  9. You cannot revert your Roth conversion
  10. As per a new rule in the Tax Cuts and Jobs Act of 2017, you cannot undo a Roth conversion, which means once you convert your traditional IRA to a Roth IRA, there is no going back. If you are not entirely sure about converting your IRA, you can opt for a partial conversion. This way, you can divide up your savings between both a traditional IRA and a Roth IRA. By doing this, you will achieve flexibility of funds and ensure you receive the best benefits of both kinds of IRAs.

To summarize

It is considered wise to pay your taxes on your retirement savings sooner rather than later, especially when it comes to Roth IRAs. Though you do make after-tax contributions to a Roth IRA, the qualified withdrawals are fully tax-free. Moreover, Roth IRAs are not subject to RMDs, and thereby, offer you greater control over your taxable income after retirement. It goes without saying that you should consider converting to a Roth IRA to make the most of the multiple advantages that it offers.

If you feel that you require more information on Roth IRAs before making a decision, consider hiring a professional financial advisor who can guide you on whether it is a suitable investment option for your retirement needs.

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