Converting funds from a traditional IRA to a Roth IRA can be a great way to provide yourself or loved ones with tax-free income later in life. However, it may not be the right move for everyone. So, before you start a conversion, you’ll need to understand two important things: 1) a Roth IRA conversion is taxable to you in the year it is completed; and 2) the trade-off is paying taxes now instead of later.
To figure out if a Roth IRA conversion is a good move for you, ask yourself the following questions:
- What will my tax bracket be when I take withdrawals?
If you expect your tax bracket to be higher or the same in retirement as it is while you’re working, you may want to consider a Roth IRA conversion to give yourself some tax-free income once you retire.
How old will I be — and in how many years — do I plan on taking withdrawals?
To get the benefits of tax-free income from a Roth IRA, your money needs to stay in the account for at least 5 years and until you’re age 59½, you become disabled or your death. So, if you’re planning to retire sooner than that, know that you’ll be taxed on any investment gains you withdraw before the 5-year mark, even though you paid taxes on the principal at the time of conversion.
Am I ready to pay the taxes now?
And if I pay taxes out of my account now — how long will it take me to make up that money in earnings? First, if you do a Roth IRA conversion, you’ll either need to pay taxes on the principal and earnings with money from the IRA or have additional money outside the IRA you can use. If you use money from the traditional IRA to pay the taxes, you’ll want to make sure you have enough years ahead of you before you take withdrawals, so you can make up for the loss of that money — and earn more.
What is the stock market doing?
If the stock market — and the value of your IRA — is down, converting to a Roth IRA may incur less taxes. That’s because you’ll pay taxes on whatever the account value is at the time of conversion. If the stock market is up and your IRA values are high, you might want to hold off on the conversion.
Do I plan to pass the money on to loved ones or use it myself?
Because Roth IRAs aren’t subject to required minimum distributions (RMDs), your money can continue to grow for as long as you live. If your spouse is your beneficiary, they can roll that money into their own Roth IRA and keep it growing tax-free. If you have a non-spousal beneficiary, they will eventually need to take RMDs, but those distributions won’t be taxed, and they can stretch over the person’s entire life.
Look at your entire tax picture when you plan to take income
It’s not enough to say, “I won’t be working, so my income will be less, therefore my taxes will be less.” There are plenty of other ways your taxes can go up or down in the future. Below are just a few.
Your taxes might decrease if you:
- Stop working
- Move to a state with lower or no income tax
- Move to a larger home with more deductible interest
- Have high-deductible healthcare expenses
Your taxes might increase if you:
- Pay off your mortgage and therefore have no deductible interest
- Take a large lump sum from a retirement plan, IRA or annuity
- Liquidate taxable investment savings or other assets
- Move to a state with higher income taxes
Talk to your financial and tax professionals before making a Roth IRA conversion
Converting a traditional IRA to a Roth IRA is all about taxes — when you pay them and how much you’ll pay. So, it makes sense to talk to your tax advisor and financial professional ahead of time to make sure you’re making a move that will be good for you now and in the future.
This informational and educational content does not offer or constitute and should not be relied upon as tax, financial, or legal advice. Your unique needs, goals and circumstances require and deserve the individualized attention of your own professionals, and Equitable Advisors, LLC (Equitable Financial Advisors in MI and TN) and its affiliates and associates do not provide tax or legal advice or services. Any tax information provided in this document is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer. The tax information was written to support the promotion or marketing of the transaction(s) or matter(s) addressed and you should seek advice based on your particular circumstances from an independent tax advisor.
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