This Is What You Need to Know about Converting Traditional IRA Accounts into Roth IRAs

The coronavirus pandemic has wreaked havoc on many people’s retirement plans. Many people are looking closely at their retirement accounts and figuring out their plans for the future.

One of the questions that you may have is whether or not it makes sense to convert your traditional individual retirement accounts (IRAs) into Roth IRA accounts. Roth IRAs are a way to reduce your tax burden if you believe income tax rates will be raised in the future. Many people believe that this is likely, particularly given the increased government spending that occurred during the pandemic, and the record national debt-over $27 trillion in late 2020.

This is what you need to know about the conversion process to determine whether or not it is right for you:

The Major Considerations When Considering Roth Conversions

As you consider converting traditional IRA accounts into Roth IRA accounts, you need to consider how taxation will affect you in the coming years. The primary difference between these two accounts is when taxes are paid.

With a Roth IRA account, you contribute after-tax income and then make withdrawals during retirement without any tax implications. Traditional IRA accounts, on the other hand, delay the tax burden until your retirement years. You save pre-tax money and pay taxes when money is withdrawn.

Which type of account is best for you depends on whether or not income tax rates are higher now or in the future when you are making withdrawals. It also depends on how your current tax bracket compares to your anticipated tax bracket in retirement. Many people believe that the rapidly aging population, record debt levels, and pandemic-related government spending will lead to higher taxes in years to come. If you believe that to be the case, then it makes sense to pay taxes now, when taxes are lower rather than down the line, after they are higher.

Additionally, Roth accounts do not have required minimum distributions, which otherwise start at age 72. These distributions can quickly raise your tax liability in retirement. These means converting to a Roth can save you considerable money down the line and help you stay out of some of the higher tax brackets.

Remember, however, taxes will be due at the time of conversion. Since tax breaks are not offered for Roth IRA contributions, you will need to pay income taxes on converted funds. This has the potential to be expensive now. However, the tax cuts and new tax brackets effective 1/1/18, are historically low and are scheduled to sunset on 12/31/25, so there are only 5 years ( and three months) left to shift money through ROTH conversions at these attractive tax rates. In retirement, you can make withdrawals from ROTHs without owing tax on the principle or any money earned.

What to Do Prior to Initiating a Roth Conversion

If you feel like you might benefit from a Roth conversion, the first thing to do is seek out professional guidance. This decision is a complex one that should not be taken lightly as the tax ramifications can be quite significant. A financial advisor or tax professional can help crunch some of the numbers and make projections that inform your decision.

Once you have made the decision to convert, you will still need professional guidance to avoid expensive mistakes. For example, conversions can sometimes trigger a taxable event, which could mean owing more money upfront than you expected. However, it is possible to engage in several small traditional-to-Roth conversions over the years to avoid this. Triggering a high tax bill now defeats the purpose of converting. Following the rules helps ensure your tax burden is minimized.

To convert to a Roth IRA properly, you will need to rollover a traditional IRA directly into a Roth account or take a distribution from the traditional account and roll it into a Roth within 60 days. If this deadline is missed, the financial implications can be quite significant. For this reason, it often makes the most sense to do a direct rollover and avoid any potential issues.

You should also make sure you understand the conversion rules. Switching back to a traditional account is generally not possible, so once you have converted there is no going back.

The Potential Drawbacks of Converting to a Roth IRA

Converting to a Roth IRA has some potential downsides. For example, the conversion is considered ordinary income, so the process could bump you into a higher tax bracket and increase taxes owed on capital gains and qualified dividends. For this reason, many people only convert in their lower-earning years.

Making a Roth conversion if you have already retired is financially risky. It can potentially decrease your Social Security payments and increase your Medicare premiums because the converted amount will be taxed as ordinary income in the year the conversion takes place. On the flip side, in some circumstances, a disciplined ROTH conversion process over a period of years can lead to your Social Security being tax free in retirement. For this reason, is often useful to seek the advice of a professional about your specific situation.

The bottom line is that Roth conversions have the potential to save you a lot of money, but you need to be careful and understand exactly how they will impact your finances, both now and in retirement. You never want to be in a position of jeopardizing your current financial situation for future tax savings that may not even be realized.

No one can predict the future. However, if the situation is right and you will not be burdening yourself with the conversion, it can be a wise move that ends up saving a lot of money.

Originally published at https://robertryerson.me on November 2, 2020.

Robert Ryerson authored the 2016 book What’s the Deal With Identity Theft?: A Plain English Look at Our Fastest Growing Crime.

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