Have you ever wondered about whether it makes sense to convert your traditional individual retirement account, or IRA, to a Roth IRA?
The main difference between a Roth and a traditional IRA is when the money is taxed. With a traditional IRA, the money goes in pre-tax and is taxed when you take it out of the account. With a Roth, it is taxed before it goes in but is tax-free when you withdraw it.
With a conversion, you can move money out of a traditional IRA, pay ordinary income taxes on that money, and move it into the Roth where it will grow tax-free.
Therefore, the most important factor that you need to know before you convert your IRA to a Roth is what your tax bracket is going to be now versus in the future. If you are nearing retirement, you’ll most likely be in a lower tax bracket in the next few years, so you might want to wait until after you have retired to do the conversion. That way, the money that you convert will be taxed at a lower rate.
If you are not sure if you will be in a lower tax bracket in the future but you still want to do a conversion, you might want to consider converting small amounts of your traditional IRA each year instead of all at once.
I think the biggest benefit of converting to a Roth IRA is the ability to pass it on to your beneficiaries without them having to pay any taxes (as long as you had the Roth opened for at least 5 years). The beneficiary will still have to take required minimum distributions (RMDs) but those distributions will be based on the beneficiary’s age, not yours.
If your spouse is your beneficiary, it gets even better. Your spouse can make it their own Roth IRA and will not need to take any RMDs during their lifetime. Then, when your spouse dies, his/her beneficiaries can take the RMDs based on their ages. This is sometimes referred to as a Stretch Roth IRA.
There are plenty of conversion calculators on the web that can give you a general idea if it makes sense to convert all or a portion of your traditional IRA. You’ll definitely want to check with you financial and/or your tax advisor to ensure you are making the right decision.
Joe Baker, CFP®
Baker Asset Management, LLC
joebaker@bakerassetmanagement.com
