Should You Convert Your IRA to a Roth?

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While there are some pretty compelling benefits to Roth investing, you could get hit with a pretty hefty tax bill when you convert. Here's what you need to know about converting a traditional IRA to a Roth, and whether or not it could be a smart move for you.

Converting your traditional IRA or 401(k) to a Roth

Since 2010, any traditional IRA account holder can convert their account to a Roth IRA, regardless of the account owner's income level, age, or how much money in the account.

And, the process is generally painless. If you already have a traditional IRA at a major brokerage, converting to a Roth is usually a matter of filling out a short form. When rolling over an eligible 401(k), you'll typically have to open a Roth IRA, and then roll the 401(k)'s assets into it. The process is usually quick and uncomplicated.

Benefits of a Roth vs. traditional IRA

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A traditional IRA can get you a nice tax break right away. If you contribute up to the maximum of $5,500 to a traditional IRA this year, you could deduct the entire amount on your 2016 tax return, as long as you meet the qualifications.

While this is obviously a nice benefit, there are a few advantages to a Roth IRA:

  • Tax-free income:You won't get an immediate tax break for Roth contributions, but your qualified withdrawals will be 100% tax-free. Even if your account balloons to several million dollars, Uncle Sam can't touch a cent.
  • Your contributions aren't tied up:Since you've already paid taxes on the money you contribute to a Roth IRA, you're free to withdraw it at any time, for any reason. Standard IRA withdrawal rules still apply to any investment profits.
  • No required minimum distributions (RMDs):Traditional IRAs and 401(k)s require you to start taking distributions by age 70-1/2. Roth IRAs have no such requirement. You can let your money grow tax-free for as long as you'd like.
  • No maximum contribution age:Traditional IRAs don't allow for contributions after you reach the RMD age of 70-1/2. On the other hand, you can make Roth contributions for as long as you have earned income.
  • Great for estate planning:A Roth IRA can allow you to set up tax-free income for your heirs that they can stretch out over their entire lifetime.

The tax bill can be a big drawback

When you convert a traditional IRA or a 401(k) to a Roth IRA, you'll have to pay income taxes on the pre-tax amount that you're converting. Generally speaking, this means the entire amount, unless you had non-deductible traditional IRA contributions (not common).

You can choose to pay the taxes on a Roth conversion in one of two ways. If you can afford to, the most beneficial option is to pay the taxes in cash, as it allows you to maximize the amount (and therefore the tax benefits) of your new Roth IRA. However, this is often not possible or practical to do, especially when converting an account with a high value.

Or, you can choose to have the taxes deducted from your traditional IRA at the time of conversion. Theoretically, you're not losing any money by doing this -- you're swapping out a higher amount of money that will eventually be subject to income tax for a lower amount of money that will not. However, you lose the potential tax-free compounding power of that amount, and you also may be subject to a 10% early withdrawal penalty if you're under 59-1/2 and withdraw money to pay tax on the conversion.

The Foolish bottom line

There are some clear benefits to having retirement assets in a Roth IRA, but you need to be aware of the tax implications before you convert. However, if you expect to be in a higher income tax bracket in retirement, you don't want to take RMDs, or want to use it in estate planning, converting your traditional IRA or 401(k) to a Roth IRA can make good financial sense.

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