Here are some insights that may be helpful, either as a reminder or as new information as you work with your accountant or investment advisor:
Defining Terms: A quick reminder of the difference between an IRA and a Roth IRA may be helpful. An IRA is tax-deferred, meaning you will pay the tax on the accumulated investments when you withdraw funds. A Roth IRA is allowed to grow tax-free.
“Well, that’s easy!” you might be thinking. Why would you ever choose to pay taxes where you can avoid them?
The Catch: When you convert funds from a 401(k) or an IRA to a Roth IRA, you must first pay the taxes on your accumulated wealth. Depending on your tax bracket, that could be a sizable check and may significantly impact your planning for retirement.
For instance, if you have $500,000 in an IRA and you decide you would like to convert it, your financial advisor may point out that you are in the 35% tax bracket at the federal level and in the 6% bracket at the state level. Your tax bill will be large, and that may be a check you can’t bring yourself to send.
When It Could Be Beneficial: There may be opportunities where conversion to a Roth IRA makes good sense, such as when an investor is in a lower tax bracket for several years. You may also expect to have a higher tax bracket in retirement, in which case a Roth conversion may be advantageous.
Generally speaking, the longer amount of time you have until retirement, the more likely it is that converting to a Roth IRA can be beneficial.
Conversion Over Time: In many cases, even when a conversion to a Roth IRA makes good financial sense, the investor may not be able to afford the tax payment. If this is the case, you can convert only the amount of your 401(k) or IRA on which you can afford to pay the taxes. Each year, you can complete a partial conversion until your retirement accounts are tax-free. This is a good way to avoid making a large tax payment at once.
Planning for retirement comes with complex questions. If you would like more information about converting to a Roth IRA, reach out to your accountant or contact us at Lawson Kroeker.