What is the best way to handle an Individual Retirement Account (IRA)? Let it sit and make money, then pay taxes on the withdrawals in retirement? Or roll it over to a Roth IRA? Do I have to pay taxes now and get tax-free money later? And can I have the taxes due on the rollover debited from the rollover account itself?
-Pat
When considering whether to convert a traditional IRA to a Roth IRA, you need to consider more than just the immediate tax burden.
While taxes play a big role here, they are not the only factor at play. So you’ll want to look at the full picture as you figure out whether a Roth conversion makes sense for your current and future finances. (And it’s wise to consult a financial advisor before taking this step, to make sure everything is done correctly.)
Traditional vs. Roth IRAs
Before we get into conversion factors, let’s briefly talk about the differences between traditional and Roth IRAs. Again, most people focus on the tax effects, but there are several other factors that separate the two types of retirement accounts. Those differences make Roth IRAs a winning choice for many people.
Some key differences between traditional and Roth IRAs include:
Load Timing: Traditional IRA contributions are (generally) tax deductible when made, and all withdrawals are taxed when made. Roth IRA contributions are not tax deductible and all withdrawals are tax-free (as long as you follow the rules). That means earnings in a Roth IRA are never taxed.
Easier access to your money: Traditional IRA withdrawals made before retirement age are subject to 10% penalties on top of income taxes. Roth IRA contributions (but not earnings) can be withdrawn at any time without penalty because you’ve already paid taxes on them, so you can access your money when you need to (once you pass the five-year conversion anniversary).
Required Minimum Distributions (RMDs): With traditional IRAs, you must start taking RMDs once you reach age 73. With Roth IRAs, you never have to take distributions if you don’t want to.
Reduced taxable income: Traditional IRA withdrawals are subject to regular income taxes, which increases your taxable income. Roth IRA withdrawals are not taxable and not included in taxable income. A lower taxable income can put you in a lower tax bracket. As an added bonus, it can help you avoid income taxes on Social Security benefits during your retirement.
Tax-free inheritance: Your heirs pay taxes on withdrawals from inherited traditional IRAs. Heirs who withdraw money from inherited Roth IRAs pay no income taxes as long as the five-year rule is met.
For these reasons, many people can benefit in the long run from converting a traditional IRA to a Roth IRA. But before you rush to take this step, think about the best way to deal with it so that you don’t end up in financial trouble. A financial advisor can help you.
When to Convert to a Roth IRA?
Because you’ll face a larger tax bill when you convert a traditional IRA to a Roth IRA, you’ll want to do this strategically. If you have a variable income, it is wise to exchange more in a year with a lower income and avoid exchanges in a year with a higher income.
You can also convert your traditional IRA in blocks instead of doing it all at once. You’ll need to keep track of multiple five-year anniversaries, but you can spread the current income tax burden over several years instead of coming up with a huge lump sum all at once.
As for timing, the further away you are from retirement, the better the conversion will serve you. The tax-free earnings in the Roth will have more time to accumulate and accelerate, leaving you with a larger tax-free savings pot for the future. Consider using this free tool to match with a financial advisor for professional guidance based on your circumstances.
When a Roth IRA Conversion Doesn’t Make Sense
There are also situations where a Roth conversion doesn’t make sense.
For example, if you are close to or already receiving Social Security and Medicare benefits, making a Roth conversion will increase your taxable income, potentially resulting in taxable Social Security and higher Medicare premiums.
Or if you’re already retired and using the money from your traditional IRA to cover your living expenses, the current tax burden can make it harder to pay your bills. Another reason to skip this strategy: You won’t have enough non-pension funds to pay the taxes, which could make the conversion a losing venture.
The five-year rule for Roth conversions
Roth IRA conversions have a special restriction: You cannot make penalty-free withdrawals from the Roth IRA before the five-year anniversary of the conversion. And this applies to each conversion separately if you spread it over several tax years.
The five-year clock starts at the beginning of the tax year in which you converted the IRA. So, for example, if you converted $25,000 from a traditional IRA to a Roth on November 15, 2022, the clock starts on January 1, 2022. That means you can withdraw without penalty after January 1, 2027. less than five full years from the actual conversion date.
This rule prevents people from eliminating the 10% tax penalty for early withdrawals from a traditional IRA. So don’t count on being able to withdraw immediately tax-free on your Roth conversion.
Dealing with Roth Conversion Taxes
It’s tempting to use some of the rollover money to pay the taxes on your Roth conversion, but that would be a big mistake.
Make sure that you regularly have enough savings to pay the full tax bill on your conversion.
Any amount you take out of the traditional IRA that doesn’t go into the new Roth IRA counts as an early withdrawal. That means that, in addition to the regular income tax liability, that money will also be subject to the 10% early withdrawal penalty.
For example, let’s say you want to convert $20,000 from a traditional to a Roth IRA. You estimate that the income tax on the conversion will be $2,000 (or 10% of the total). If you withhold $2,000 from the rollover amount, your Roth conversion will only be $18,000.
The remaining $2,000 is considered an early withdrawal… and you’ll end up owing another $200 in IRS penalties. Plus, your Roth will have less money to begin with, and that means lower tax-free income over time.
Consider consulting a financial advisor to ensure your retirement plan makes sense for your goals.
In short
Don’t use part of the conversion money to pay taxes. It will cost you penalties now and profit growth in the long term.
Tips for investing and retirement planning
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Consider working with a financial advisor for guidance on dealing with retirement accounts. Finding a qualified financial advisor doesn’t have to be difficult. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisors for free to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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When planning your income after retirement, keep Social Security in mind. Use SmartAsset’s Social Security Calculator to get an idea of what your benefits might look like in retirement.
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Have an emergency fund on hand in case you encounter unexpected expenses. An emergency fund should be liquid – in an account that is not at risk of significant fluctuations like the stock market. The trade-off is that the value of liquid cash can be eroded by inflation. But with a high-interest account, you can earn compound interest. Compare savings accounts from these banks.
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Are you a financial advisor looking to grow your business? SmartAsset AMP helps advisors connect with leads and provides marketing automation solutions so you can spend more time making conversions. Learn more about SmartAsset AMP.
Michele Cagan, CPA, is a financial planning columnist at SmartAsset, answering reader questions about personal finance and tax topics. Do you have a question that you would like answered? Email AskAnAdvisor@smartasset.com and your question may be answered in a future column.
Please note that Michele is not a participant in the SmartAsset AMP platform, nor an employee of SmartAsset, and she received compensation for this article.
Photo credits: ©iStock.com/dikushin, ©iStock.com/vm
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