If you’re preparing for retirement or are already retired, you’re likely familiar with two of the most popular types of IRAs. There’s the traditional IRA, which gives you a tax deduction upon contribution and offers tax-deferred growth. However, distributions from the IRA in retirement are subject to income tax.
There’s also the Roth IRA. The Roth doesn’t offer an upfront contribution, but does have tax- deferred growth and tax-free withdrawals as long as you are over age 59½ when the withdrawals are made.
What happens if you decide you want your traditional IRA to be a Roth IRA? Fortunately, the IRS allows you to convert your traditional IRA to a Roth. When you do a Roth conversion, you pay taxes on your accumulated growth and possibly on any deductions you received for contributions. After the taxes are paid, your funds are then converted into a Roth IRA.
Is a Roth conversion right for you? It depends on your unique goals and needs. Below are three signs a Roth IRA could be a good idea. If any of these sound familiar, you may want to further investigate a conversion.
1. You want to increase your after-tax retirement income.
Taxes are often a primary motivator for doing a Roth conversion. When you take retirement income from a traditional IRA, the entire distribution is taxable. When you withdraw funds from a Roth IRA after age 59½, the distribution is tax-free.
A conversion allows you to transform taxable income into tax-free income, thereby increasing your after-tax cash flow. Of course, you do have pay taxes when you do the conversion. However, if you have the money available to pay that tax bill, a conversion could be a great way to increase your disposable income in retirement.
2. You want to maximize the benefit for your heirs.
It’s possible you may not need income from your IRA in retirement. Rather, your primary goal may be to leave as much money as possible to your beneficiaries. Unfortunately, there are a few components of the traditional IRA that could erode the amount of money your heirs receive.
First, there are the required minimum distributions, or RMDs, which start at age 70½. These are mandatory withdrawals you must take from your traditional IRA, whether you need them or not. They start at a relatively low percentage, but increase each year as you get older. Also, your heirs will likely have to pay income taxes on the benefit they receive from your traditional IRA. Although there may be options for them to spread the taxes over a long period of time, there’s little flexibility to avoid the taxes.
With a Roth, there are no RMDs and your heirs won’t have to pay taxes on the benefit. That means you can convert to a Roth and avoid some of the asset erosion that can come with a traditional IRA.
3. Your income exceeds the Roth thresholds.
Depending on your income, you may be unable to contribute to a Roth IRA. In 2016, if you are a single person earning more than $132,000, you are unable to contribute to a Roth. For married couples, that number is $194,000.1
However, you can contribute to a traditional IRA and then convert that IRA into a Roth. The traditional IRA has income limitations for taking the contribution deduction, but there are no limits for simply contributing. That means you likely won’t get the deduction, but you can still open a traditional account.
Once you open the traditional IRA, you simply perform a conversion, in which you pay taxes on the converted amount and then deposit the money into a Roth. You will then get all of the tax advantages that come from owning a Roth IRA.
Considering a Roth conversion? Contact us at Coventry Financial Group. We can analyze your goals and needs and help you decide whether a conversion is right for you.
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