Should I Convert My Traditional IRA to a Roth IRA?

One of the keys to maximizing your retirement savings is choosing the right retirement accounts to begin with. Traditional and Roth IRAs are both excellent retirement savings vehicles, but the right one for you depends on your own timeline and where you expect to be financially in retirement.

Traditional IRAs are tax deferred, so your contributions will reduce your taxable income in the year you make them, but you pay taxes on your initial contributions and any interest you've earned when you retire. Roth IRA contributions don't reduce your taxable income in the year you make them, but then you don't have to pay taxes on any of the withdrawals.

The idea of tax-free distributions is appealing because you'll be able to keep more of your retirement savings for yourself rather than giving it back to the government, and it leaves many to question whether they should convert their traditional IRA to a Roth IRA. I'll discuss the pros and cons of this strategy below to help you determine if it's your best move.

Reasons to do a Roth conversion

If you believe that your income will be higher in retirement than it is today, it makes sense to keep your money in a Roth account. This may be the case for younger workers who are just beginning their careers and are currently earning a low wage. It's possible that income from Social Security benefits and retirement accounts may put them into a higher income tax bracket in retirement than they are in today.

Of course, it's impossible to predict exactly what your income will be or how income tax brackets might change with time, so you can only base your decision on your best guess. If you believe there's a good chance that you could end up paying less in taxes if you paid it now rather than waiting until retirement, it may be wise to do a Roth IRA conversion.

Single adults who earn more than $137,000 and married couples earning more than $203,000 in 2019 are not eligible to make direct contributions to a Roth IRA, but a Roth IRA conversion is a great way to get around this. You open a traditional IRA and put the funds in there, and then you're allowed to convert it to a Roth account. This is called a backdoor IRA. It's a nice option if you believe your income is lower this year than it will be in the future and you'd like to reduce the amount you'll pay in income taxes.

Traditional IRAs have required minimum distributions (RMDs) once you reach 70 1/2. This is the government's way of making sure that it receives tax revenue on the funds. RMDs are determined by your age and the value of the IRA. You can calculate yours by using this worksheet.

Roth IRAs, on the other hand, have no RMDs because you already paid taxes on the money, so you can leave it in the account for as long as you'd like, and it will continue to grow. If you pass the account onto your heirs when you die, they won't have to pay any taxes on the money either.

Reasons not to do a Roth conversion

If you believe you're in a higher income tax bracket now than you will be in retirement, a Roth IRA conversion isn't a smart choice. This is usually the case for adults that are at the peak of their careers. When you do a conversion, you're taxed on all of that money in the year you complete the conversion. If you're in a higher income tax bracket, you could end up giving much more of your savings back to the government than if you'd just left it in your traditional IRA and paid your taxes in retirement.

You also need to make sure that you have the money on hand to cover the additional taxes in the year that you make the conversion. If you're under 59 1/2, you won't be able to use any of the money in your retirement accounts unless you want to pay a 10% early withdrawal penalty on top of the income tax. So you need to have the extra cash set aside in savings. Keep in mind that the Roth conversion could push you into a higher income tax bracket for the year, so you could end up paying even more than you anticipated. However, this strategy will help you to reduce your RMDs and income taxes in retirement, so extra taxes in this year may be worth these long-term benefits for some.

You should note that there's a five-year holding period with Roth conversions. It begins Jan. 1 of the year you make the conversion. If you withdraw any earned interest before this holding period is up, you could end up paying taxes on this amount even though it is in a Roth account. But if you don't intend to touch your retirement savings for a few decades, this may not be a problem.

Roth conversions are also permanent as of 2018, so you can't reverse this decision later if you decide it was a mistake. For this reason, it's important to think through this decision carefully. If you do decide to go through with the Roth conversion, all you need to do is contact the firm that manages your IRA and request that the funds be converted to a Roth IRA.

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