Should You Convert Your IRA to a Roth?

Investors have been discussing whether a traditional or Roth IRA is best as long as they have both been around. One factor that might tip the scales toward a Roth is a downturn in the value of your investments. If you have a traditional IRA, a decline may provide a valuable opportunity to pay less taxes if you convert your traditional IRA to a Roth IRA.

How Are They Different?

Contributions to a traditional IRA may be deductible, depending on your modified adjusted gross income (MAGI) and whether you (or your spouse) participate in a qualified retirement plan, such as a 401(k). Funds in the account grow tax deferred.

On the downside, you generally must pay income tax on withdrawals from a traditional IRA. In addition, you’ll face a penalty if you withdraw funds before age 59½ — except in a small handful of exceptions — and you’ll face an even larger penalty if you don’t take your required minimum distributions (RMDs) after age 72.

Roth IRA contributions, on the other hand, are never deductible. But withdrawals — including earnings — are tax-free as long as you’re age 59½ or older and the account has been open at least five years. In addition, you’re allowed to withdraw contributions (not earnings) at any time tax- and penalty-free. You also don’t have to begin taking RMDs after you reach age 72.

The ability to contribute to a Roth IRA is subject to limits based on your MAGI. Fortunately, no matter how high your income, you’re eligible to convert a traditional IRA to a Roth, but you’ll have to pay income tax on the amount converted.

How Can You Save Tax Dollars?

This is where the “benefit” of a downturn in the value of your investments comes in. If, for example, your traditional IRA is invested in the stock market and has lost value, converting to a Roth now rather than later will minimize your tax hit. Plus, you’ll avoid tax on future appreciation when the market goes back up.

It’s important to think through the details before you convert. Ask yourself some important questions when deciding whether to make a conversion. First, do you have money to pay the tax bill? If you don’t have enough cash on hand to cover the taxes, you may have to dip into your retirement funds. This will erode your nest egg. The more money you convert and the higher your tax bracket, the bigger the tax hit.

Also, what’s your retirement horizon? Your stage of life may affect your decision. Typically, you wouldn’t convert a traditional IRA to a Roth IRA if you expect to retire and start drawing down on the account soon. Usually, the goal is to allow the funds to grow and compound over time without any tax erosion.

Keep in mind that converting a traditional IRA to a Roth isn’t an all-or-nothing deal. You can convert as much or as little of the money from your traditional IRA account as you like. So, you might decide to gradually convert your account to spread out the tax hit over several years.

Is It the Right Move for Me?

Of course, there are more issues that need to be considered before executing a Roth IRA conversion. If this sounds like something you’re interested in, contact us to discuss whether it’s the right move for you.

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