When saving for retirement, you have several tax-deferred options to choose from, however, few of those options allow you to withdraw your earnings tax-free. One option is to open a Roth IRA, but those funds have low contribution limits and if your income exceeds the established limits, you’re not even eligible to contribute!
The good news? You can take advantage of tax-free withdrawals in retirement by completing a Roth conversion. To help you decide if this is the right financial move for you, the financial advisors at Maggi Tax Advisory and Financial group explain the pros and cons of a Roth conversion.
What is a Roth Conversion?
A Roth conversion involves changing the account classification from a tax-deferred account such as a 401(k), 403(b), or traditional IRA into a Roth account where you can withdraw your money tax-free. Beginning in 2010, the federal government allowed investors to convert their traditional IRAs into Roth IRAs, regardless of the amount of income they earned. In addition, investors have the potential to convert much more than $6,000 or $7,000 a year, which are the current Roth IRA maximums (depending on age).
The Pros of Roth Conversions
Some of the biggest benefits of a Roth conversion include:
Tax-free withdrawals. Because you pay taxes on Roth contributions upfront, you can withdraw your original contributions at any time without paying additional taxes. In addition, if you are 59 ½ or older and the account has been open at least five years, you can withdraw your earnings tax-free!
Reduced tax burden for heirs. The rule for a traditional IRA is that non-spousal heirs must draw down the entire account within 10 years, most likely increasing the amount of taxes. Completing a Roth conversion and paying taxes now could significantly reduce the amount of taxes heirs would have to pay in the future.
Zero minimum distributions required. Unlike other types of retirement accounts that require you to start taking minimum distributions at the age of 72, you never have to take a required minimum distribution from a Roth. This allows your money to grow tax-free for as long as you want!
Tax diversification. A lot of people contribute to tax-deferred accounts to be in a lower tax bracket during retirement. However, unless you plan to retire soon, you have no idea what that tax bill will be! Depending on tax rates during your retirement years, you may even end up paying higher taxes. A Roth conversion can help you diversify your funds, keeping them in separate tax categories.
No time restrictions on contributions. As long as you have earned income, you can contribute to a Roth for as long as you want…even during retirement!
It can be completed in phases. One major advantage to Roth conversions is that you can convert as little or as much as you want at different stages! In fact, it is often more advantageous to do it that way because you can convert enough to stay in your current tax bracket without going into the next.
The Cons of Roth Conversions
Here are some of the potential drawbacks to Roth conversions.
The tax bill. Because you can only contribute after-tax dollars to a Roth, you must pay taxes on the amount you convert at your current tax rate. Also, if you are converting an account with non-deductible contributions, you only need to pay taxes on the contributions you deducted. This is where a knowledgeable financial advisor comes into play.
Potentially higher taxes. When you complete a Roth conversion, the taxes are at your current rate. Depending on your finances during retirement, you may pay more taxes now than if you had kept the money in tax-deferred accounts.
The waiting period. To avoid paying a penalty or taxes, you must wait at least five years after the conversion to withdraw your earnings. If you are nearing retirement and think you will need the money in less than five years, a Roth conversion is not the best option for you. It is important to note that you can withdraw original contributions at any time.
It’s irreversible. After completing a Roth conversion, you can not put the money back into a tax-deferred account.
Interested in learning more about Roth conversions? Contact the financial advisors at Maggi Tax Advisory and Financial Group today to schedule a consultation to discuss your investment options. We can be reached at our greater Tampa Bay locations: Hillsborough at 813-590-6806, Pinellas at 727-334-7869 and Pasco office 727-334-7891.