While tax season has come and gone this year, it is never too early to start planning for a conversion from a traditional IRA to a ROTH IRA. Depending on your situation will dictate if you would want to make this conversion and at what time in your life. But first, we will look at the main differences between the two types of accounts.
A traditional IRA is one that is not taxed before the funds being invested in the IRA. These contributions will lower your taxable income in the year the contribution was made. A traditional IRA will generally make more sense for someone in a higher tax bracket as the tax benefits will be more significant and meaningful at the time they were made. Then the contributions and all of the earnings will grow tax deferred until you reach retirement age and can make withdrawals, age 59 and ½. However, traditional IRA’s also have a required minimum distribution that starts at age 70 and ½. We will look at how those can affect your choices a little later.
A ROTH IRA is taxed before the contribution being made to the account. These do not help with your current tax liability but all the contributions and earning will grow tax-free until you reach retirement age and then there are no required minimum distributions to concern yourself with. Some people think ROTH accounts are better suited for people who are early in their career with lower tax rates. The reason for this is that they will most likely be in higher tax rates in retirement.
I personally feel that a ROTH account if you qualify is the better option regardless of your earnings and tax bracket. The reason for this line of thinking is that I feel tax rates in the future will continue to rise as the government will have to raise taxes to pay for services and the rising debt our country has. Also, there will be more people in retirement than there will be joining the workforce in the coming years so the tax base will not be as large as it is currently. But those are my personal opinions, and you may think differently or have a different view on this situation.
When you make a withdrawal from a traditional IRA is will be taxed at the ordinary income tax bracket that you are in when the withdrawal is made. On the other hand, a ROTH withdrawal is tax-free and will not be reported as income. If like me, you think you may be in a higher tax bracket when you are retired the ROTH is much more attractive.
Now if you have a traditional IRA and wish to convert it to a ROTH IRA that is possible but timing in this venture could be crucial and could cost or save you thousands in taxes. If you are earning a significant salary and in one of the upper tax brackets, a ROTH conversion may not make the best sense at the present time. However, if you were not working for part of the year and your taxable income places you in a lower tax bracket, this could be an excellent opportunity to make such a conversion. Also, you can convert a portion of a traditional account and spread the tax implications over several years and not tax the entire tax hit in one year.
If you are still working and have a traditional IRA at age 70 and ½ it may make sense to convert portions of the traditional IRA’s required minimum distribution to a ROTH account provided you have enough earned income in the year, you make the conversion. That means if you convert $10,000 you will need at least $10,000 in earned income to do so.
Conversions and the tax implications of IRA’s can be complex and extremely complicated at times. When in doubt seek the advice of a financial planner or CPA that is knowledgeable of your financial situation.
If you need more information, please feel free to leave a comment or send me a message directly.
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