Since its inception in 1974, the IRA has become one of the most popular vehicles for saving for retirement. In fact, according to a 2013 analysis from the Employee Benefit Research Institute, there were more than 25 million IRAs in the United States at that time. Those accounts held a combined $2.46 trillion in assets.1
Much of those assets are held in traditional IRAs. The funds enter the IRA either as direct contributions or as a rollover from a 401(k) plan at a former employer. The traditional IRA offers some unique benefits, including deductions for contributions and tax-deferred growth.
However, the Roth IRA has been growing in popularity in recent years. While the Roth also offers tax-deferred growth, it does not offer an upfront deduction for contributions. Instead, the Roth provides tax benefits on the distribution side. You can take tax-free withdrawals from the Roth IRA, assuming that the account has been open for at least five years and that you are age 59½ or older.
As you might imagine, a tax-free income stream can be beneficial in retirement. Obviously, it reduces your tax liability. However, it also reduces your taxable income, which impacts the taxes you pay on your Social Security benefits and the premiums you pay for Medicare Part B.
There are other benefits to a Roth. One is that you aren’t required to take distributions at age 70½, as you are in a traditional IRA. That means you can allow your assets to grow as long as you’d like. Also, when you pass away, your beneficiaries receive their benefit tax-free, which isn’t the case with a traditional IRA.
What if you have a traditional IRA but want to switch to a Roth? You can do that through a strategy called a Roth conversion. As the name suggests, it’s basically the process of converting traditional IRA funds into a Roth account. While it may be the right process for you, there are a couple of important points to consider:
The 5-year rule. As mentioned above, for your distributions from the Roth to be tax-free, you must be either 59½ or older, disabled or dead. Your Roth also must be at least five years old. If you need income within five years, a Roth conversion may not be right for you, as you won’t be able to take advantage of one of its most attractive benefits.
The tax obligation. Remember, during a Roth conversion, you are changing your funds from a taxable to a tax-free status. You don’t get to simply write off the tax liability on the traditional IRA. Rather, after the conversion you have to pay income taxes on the deductible contributions and growth that were converted out of the traditional IRA.
It’s often a wise strategy to pay those taxes with non-IRA funds. Technically, you can withhold the taxes from the converted amount. However, to fully realize the benefits of the Roth, you want to fund it as much as possible. Consider paying the taxes with other funds so all of the traditional IRA assets can move into the Roth. If you don’t have other funds to pay the tax bill, consider whether it’s the right strategy for you.
Thinking about a Roth conversion? Let’s talk about it. Contact us at Jerry Adams Financial Strategies. We can analyze your goals and needs and help you develop the most appropriate strategy. Let’s connect soon and start the conversation.
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