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As you start thinking about your retirement, one of the questions that may come up for you is if you should convert your Traditional IRA to a Roth IRA. There are a few different factors to take into consideration when pondering this question and we wanted to explore some of the benefits and drawbacks of implementing such a strategy.
As a reminder, everyone’s situation is completely different, and this blog is not intended to be advice to your specific situation.
Before we get into the benefits and drawbacks of converting your Traditional IRA into a Roth IRA, let’s discuss the differences between them. One of the main differences between these two types of accounts is that contributions to a Traditional IRA are made on a pre-tax basis while contributions to a Roth IRA are made with after-tax dollars.
Furthermore, after you reach the age of 59 ½, withdrawals from your Traditional IRA are taxable while withdrawals from your Roth IRA are tax free (providing the money has been in the account for at least 5 years).
Of course, there are further differences between a Traditional IRA and Roth IRA, and we encourage you to read our earlierblogthat goes into more detail on the both of them.
So now, let’s get into some of the benefits and drawbacks of utilizing a Roth IRA conversion for a Traditional IRA.
Some Benefits:
- Tax Free Withdrawals:If you do convert your Traditional IRA to a Roth IRA, your withdrawals after you reach the age of 59 ½ are tax free, providing the account has been open for at least 5 years.
- No RMD Requirement:For Roth IRAs there are no required minimum distributions (RMDs) on your account. For those of you that do not know, an RMD is a withdrawal that must be made by the account holder of a retirement account after they reach a certain age. With a Roth IRA, this rule does not apply so you can continue to have your money invested in the account without taking a required withdrawal.
- Tax Diversification: Having multiple buckets of money in retirement, both taxable and tax-free, can be beneficial to your overall retirement plan.
- Estate Planning Benefits:When retirement account assets are passed down to the next generation there are certain rules in place that require the beneficiaries to take withdrawals on that money over a certain period of time.
For example, if you have a Traditional IRA and upon your passing, it is transferred to a non-spouse beneficiary, that beneficiary will have to make taxable withdrawals on that account to have it fully liquidated within 10 years of your passing. The tax rate is at the beneficiary’s current tax level, which for those in the prime of their working years, can be at the higher end of their range.
For those that pass on a Roth IRA, this 10-year rule still applies, however the withdrawals made by the beneficiary will be tax-free.
- Locking in Current Tax Rates:If you think the current tax levels are lower now than they will be in the future, you may consider a Roth IRA Conversion to pay taxes at that current level but not have to in the future as you would with a Traditional IRA.
Just a quick disclaimer on the above, Rockline Wealth Management does not offer tax or legal advice or services, and you should consult a tax or legal professional to discuss your specific situation.
Although we listed the benefits above, we would be remiss not to mention some of the drawbacks of converting your Traditional IRA to a Roth IRA.
Some Drawbacks:
- Immediate Tax Impact:When you take money out of the Traditional IRA and convert to a Roth IRA, you owe taxes on that money in that year. Something very important to note about paying those taxes is that if you do not pay those taxes with after-tax dollars and instead dip into the funds from the Traditional IRA to do so, this could result in a 10% penalty if you are under the age of 59 ½.
- Potential to Enter a Higher Tax Bracket:When you make Roth IRA conversions, the additional income that is shown on your taxes that year could potentially push you into a higher tax bracket. Being aware of this can help you to plan accordingly.
- Impact to Cash Flow:As mentioned earlier, to ensure that you do not incur a 10% penalty on the money in your retirement account if you are converting it to a Roth IRA, you will have to pay the taxes with after-tax dollars. By doing this, you can limit the amount of cash you have on hand depending on how steep the tax bill will be.
- 5 Year Rule:Something to note with a Roth IRA is that no matter your age, you cannot start to take penalty-free withdrawals on your account until it has been open and funded for 5 years. Understanding this can help you better plan for how you can utilize those newly converted funds.
- Opportunity Cost:Being that you must pay taxes on the Traditional IRA money that you are converting to a Roth IRA, there may be opportunity risk as the funds used to pay the tax are no longer able to be utilized.
The Final Word:
As described above there are benefits and drawbacks to a Roth IRA Conversion. At the end of the day there are several factors that you should take into consideration when deciding if this is right for you. Of course, there are other factors to consider and more intricate details involved in this process. Everyone’s situation is different, and we would encourage you to speak with a financial professional about your specific scenario.
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Disclaimer:
Rockline Wealth Management (RWM) is a registered investment adviser located in Plainview, NY. RWM is registered with the U.S. Securities and Exchange Commission. Registration of an investment adviser does not imply any specific level of skill or training and does not constitute an endorsement of the firm by the Commission.
Rockline Wealth Management does not offer tax or legal services. The information in this material is not intended as tax or legal advice. Please consult legal or tax professionals for specific information regarding your individual situation.
Real-life examples given in this blog should not be viewed as guaranteed outcomes when investing. Past performance is not indicative of future results and every individual’s investment circumstances are different. Individuals should consult their financial professional before implementing their investment plan.
A Roth IRA offers tax-free qualified withdrawals of earnings from the account. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.