Roth IRAs offer an excellent way to save for retirement, as they allow tax-free withdrawals and bypass RMD rules.
As you consider Roth conversion options, there are a few important points you must keep in mind. Here are a few:
Taxes
Converting from a traditional to Roth 401(k) depends on your tax liabilities; to best assess this decision, seek advice from an accountant or financial professional. Traditional contributions are tax-deductible while earnings accrue tax-deferred until retirement age when withdraws are tax-free whereas with Roth IRAs, taxes must be paid upfront but withdrawals remain tax-free.
If you have enough time and expect to be in a lower tax bracket in retirement, converting from a traditional to Roth IRA might make sense. But you will need the means to cover federal and state income tax liabilities due on this conversion, which will lower your account balance; having cash available or other non-retirement assets which could offset these taxes makes the move more viable, according to Damaryan.
Withdrawals
Roth IRA withdrawals in retirement are tax-free, making this account an indispensable component of your estate planning strategy.
Rollovers from traditional 401(k) accounts into Roth IRAs may be taxed in the year you convert, though income taxes might be lower in that year compared to retirement. If possible, consider spreading out the conversion process over several years for optimal results.
Your options to convert nondeductible IRA balances to Roth IRAs also include earnings from those contributions; however, IRS regulations prohibit cherry-picking only nondeductible balances for conversion; any earnings from those contributions should also be included as part of your total conversion amount. Furthermore, five-year rule still applies and early withdrawal may incur a 10% penalty fee; as your time horizon expands it may become increasingly advantageous to move savings away from pretax accounts into Roth IRAs so as to build up federally tax-free funds in preparation for retirement.
Required minimum distributions
As well as taking tax considerations into account, converting traditional IRA assets to Roth retirement accounts requires taking required minimum distributions (RMDs) during the year of conversion. This could wreak havoc with one’s retirement plans by shifting them into higher tax brackets and raising income taxes accordingly.
Households who want to avoid taxes when making their Roth conversion should do it during a year when their income is lower and ensure their pre-tax IRA assets meet all requirements under IRS statutes, which prohibit holding collectibles such as gold and other bullion, while discouraging investments in private companies and real estate.
Consider also that when you convert your IRA, the five-year hold period for Roth withdrawals begins on January 1 of the year you converted, regardless of subsequent conversions to other Roth accounts. This rule, known as aggregation rule, prevents cherry-picking of after-tax IRA balances – keeping contributions and earnings intact to use later as conversion opportunities.
Partial conversions
Converting your traditional retirement savings into Roth IRAs doesn’t need to happen all at once; you can do it gradually over multiple years if you want to minimize tax consequences of conversion. This strategy may work particularly well if your 401(k) contributions and earnings will also be converted as the IRS follows a pro-rata rule when calculating its tax consequences, looking at all assets converted and their proportion of never taxed accounts relative to total amount being converted.
Repeated partial conversions may help you stay out of higher tax brackets as required minimum distributions or capital gains taxes are assessed on any remaining balance in your investment account after retirement, also known as “tax bracket arbitrage.” However, if your conversion exceeds your current tax bracket by overshooting by more than the threshold allowed for conversion, ordinary income taxes must be withheld from that portion in that same year it was converted.
