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One of the larger misconceptions about retirement is that taxes will no longer be a significant factor since you’re no longer working. While you may be in a lower tax bracket, taxes will likely continue to be an important part of your retirement budget. One tool to help limit your tax burden in retirement is a Roth IRA. Converting a Traditional IRA to a Roth IRA is a popular strategy to take advantage of its tax-free growth.

Roth vs Traditional IRA

Traditional IRAs are taxed when you begin to take distributions. When you convert a traditional IRA into a Roth, that conversion is treated as a withdrawal. This means you will have to pay taxes based on the amount of the conversion. Qualified withdrawals from a tax-deferred plan like a traditional IRA are taxed at your ordinary income tax rate, not at the more favorable capital gains rates. Withdrawals made prior to age 59 ½ may result in a 10% IRS penalty tax.

Is a Roth Conversion Right for Me?

Because of the tax implications of a Roth IRA conversion, it’s important to be aware of your current tax situation. If you are looking to convert a large amount or if you are near the upper limit of your current tax bracket, the conversion may push you into a higher tax bracket. Instead of converting the entire amount in one year, it may be better to spread the conversion out over several years to avoid a tax bill that can be higher than anticipated. Traditional IRA account owners should consider the tax ramifications, age and income restrictions in regards to executing a conversion from a Traditional IRA to a Roth IRA.

For those who can handle the tax bill associated with a conversion, retirees can take advantage of Roth IRAs’ unique treatment of required minimum distributions (RMDs). With traditional IRAs and 401(k)s, you have to begin taking RMDs if you are retired at age 70 ½. Roth IRAs do not require you to take RMDs at any age. This means, if you do not need the money, you can continue to let the Roth IRA grow tax-free rather than having to take withdrawals from a traditional IRA and paying taxes on that money.

Another advantage with a Roth IRA is that you can continue to contribute to it as long as you continue to work. With a traditional IRA, you are not allowed to contribute once you reach age 70 ½. For Roth IRAs, you can continue to contribute at any age, meaning you can continue to grow your savings well beyond the limit of a traditional IRA.

Converting to a Roth IRA is a complicated decision and may not be appropriate for everyone. Working with a financial or tax advisor can make this process easier and may help you limit the tax burden on your conversion.

Ben Schaefer

Ben Schaefer

Senior Vice President, Financial Advisor