Converting to a Roth IRA allows you to take advantage of tax-free withdrawals upon retirement; however, pre-tax contributions and earnings that have been transferred over will still require tax payments when converted.
Experts advise spreading conversions over multiple years in order to minimize the initial tax hit, taking into account your tax bracket and income throughout the year.
How Much Can I Convert?
No hard and fast rule exists when it comes to how much of your IRA you should convert to a Roth. But for maximum tax-free growth over many years (even decades), invest dollars that you won’t use during retirement into conversions that allow them to grow tax-free for years or decades to come.
To avoid incurring a 10% penalty, you should wait to withdraw converted amounts until after age 59 1/2 to make withdrawals later on in life. This allows your money time to grow before withdrawing it later on.
To pay the income tax owed on a conversion, it may be tempting to tap your other retirement accounts or 401(k). Unfortunately, doing so would set back your savings goals while subjecting them to additional penalties such as 10%. Instead, personal savings should be used instead as payment towards this cost of conversion.
Taxes on the Conversion
As it’s important to keep income taxes in mind when considering Roth conversion, it is best done when there is sufficient cash available from elsewhere rather than raiding retirement savings for paying taxes due.
Consider future tax rates when making a Roth conversion decision. It could be that decades of growth in a Roth account would outweigh any conversion taxes payable today.
An effective way to switch from traditional IRA to Roth is a trustee-to-trustee rollover, which allows funds to move directly from your company records into your Roth provider. If they issue checks to you instead, 60 days must pass before these funds become subject to income tax and a 10% penalty tax.
Age Requirements
People typically should convert to Roth accounts during periods when their income will be lower than what it will be when retiring, to mitigate tax hits that can be paid off over decades of earnings growth within their Roth.
Partial Roth conversion is possible, but because the government takes into account your entire account balance – including pretax contributions as well as nondeductible ones – when calculating what taxes must be paid, only consider it if you have cash on hand or other nonretirement assets available that can help pay the resulting tax bill.
Additionally, Roth funds must be held for five years before withdrawing them or else face a 10 percent penalty fee – this policy exists to discourage people from withdrawing them early for retirement needs; it does not apply to withdrawals of earnings that weren’t taxed at the time of conversion.
Fees
If you plan on rolling over funds from a traditional 401(k), it is advisable to consult your company’s administrators beforehand in order to receive all of the paperwork that needs to be filled out and signed.
Once you have your paperwork together, the next step should be calculating how much income tax will be due on any money converted. Make sure you set aside enough cash outside your 401(k) plan to cover this bill instead of depleting its funds to pay the tax bill.
Consider spreading out the costs over multiple years rather than taking on one large sum at once, to prevent being thrust into higher income tax brackets.
Before making the switch, it would also be prudent to consult a financial planner who will provide projections showing you how converting may affect both taxes and retirement savings.
