A Roth IRA offers more flexibility than a Traditional IRA because (under qualifying circumstances) you have the ability to take tax-free withdrawals or to postpone taking withdrawals in retirement, if you prefer. You can convert money from a Traditional IRA to a Roth IRA in order to take advantage of that flexibility, but that doesn’t mean that you should. It may come at a price that does not make sense for you.
The first consideration is whether you have the funds to pay the taxes due. If you received a tax deduction when you contributed money to your traditional IRA, then you will have to pay the taxes on those funds when you convert. If you do not have enough money to pay the taxes on a full conversion, then you may want to only convert part of it or none at all.
Although you can pay the conversion taxes out of the proceeds of the Traditional IRA, you probably don’t want to do that. Not only will it reduce the amount of money that you are saving for retirement, but you will also be hit with a 10 percent tax penalty on the amount used to pay the taxes if you are younger than age 59½.
A related consideration is that your conversion amount will be considered to be income, and that may put you in a higher tax bracket. In 2012 for a married couple filing jointly, the tax rate was 15 percent on income between $17,400 and $70,700, or 25 percent on income between $70,700 and $142,700, and 28 percent on income between $142,700 and $217,450. Not only might your conversion be taxed at a higher rate than you currently pay, but it may also cost you some of your current tax credits and deductions, as many are reduced for people with higher incomes.
Tax credits and deductions that may be affected by a conversion include:
• Child Tax Credit
• Education – Reduced financial aid ability
• Itemized Deductions
• May owe more tax on Social Security or may pay more for Medicare
• May require payment of estimated taxes to avoid penalties
• Roth Contributions – may cause you to exceed income limits to make contributions
These additional tax expenses may make a conversion too costly to be worth your while. Your taxable income and tax rate at the time of conversion are important considerations. If you think tax rates will be higher when you retire, you may want to convert to a Roth IRA and pay taxes now. Paying taxes on the taxable amount you convert at today’s lower tax rate could be a real retirement advantage. If you think you will be in a lower tax bracket in retirement, the taxes you pay by converting today could end up being higher than the taxes you’d pay when you’re ready to make withdrawals. You may wish to consult a tax advisor for assistance.
Note: If you have made any non-deductible IRA contributions, the Pro-Rata Rule requires all IRAs to be treated as one, which includes traditional, SEP, and SIMPLE IRAs. It is not possible to convert after-tax (non-deductible) contributions with no income tax consequences.
One of the advantages of a Roth IRA is that you can take out the amount you contributed for any reason without paying taxes (as it is already after-tax money). However, to take a qualified distribution including the earnings in the account and avoid the 10 percent early withdrawal penalty, you have to wait five years first, and the clock starts ticking when you convert the money. If you think you may need the money before the five years is up, it’s best not to convert. For example, if you are aged 57 and you’re hearing rumors about an upcoming layoff at work, you might want to tap into your IRA as soon as you turn 59½ rather than waiting the five years.
Finally, Roth IRAs have significant benefits for estate planning. The funds remaining in the account after your death are passed on to beneficiaries free of taxes. Because you don’t have to take withdrawals in retirement if you do not want to, you may be able to leave more of your estate to your beneficiaries tax-free than with other types of retirement accounts. If you suspect that you will be leaving a large estate, converting your traditional IRA to a Roth account can give your family big benefits down the line.
Converting to a Roth IRA is not a decision to take lightly, nor is it for everyone. If you understand the benefits and the implications, then you’ll be better prepared to make the right decision for you and your family.
Bill Lawson is a local State Farm agent. His office is located at 4227 Fort Henry Drive, Suite B, in Kingsport. His business hours are 8:30 a.m. to 5:30 p.m., Monday through Friday, and at other times by appointment. To schedule an appointment, call the office at 423-239-9429.comments powered by Disqus