Roth IRAs allow you to access earnings tax-free if you are over 59 1/2, but conversion from an employer-sponsored retirement account into one is considered taxable event.
Typically, to reduce your tax bill and report less income on tax forms, it is advisable to convert during a down market. Losses from other investments may also help offset your income that will be reported.
What is a Roth IRA?
Roth IRAs are tax-deferred retirement accounts where after-tax dollars can be invested tax-free until withdrawal at age 59 1/2. There is one major drawback however: you’ll have to pay income tax if withdrawing funds before age 59 1/2.
Some individuals whose income exceeds traditional IRA contribution limits can still take advantage of its benefits by opening and then converting a nondeductible IRA into a Roth, known as backdoor Roth IRAs.
It’s usually beneficial to convert during years with lower taxable income than normal, since you will owe taxes on any amounts you roll over and it may be difficult to avoid paying them without cash on hand or other non-retirement assets like tax losses or credits. The coronavirus pandemic provided many Americans with an opportunity to do just this and use that extra money towards paying their conversion tax bills.
How do I convert my 401k to a Roth IRA?
People frequently work for multiple employers throughout their career and accumulate multiple traditional 401(k) plans, which they must manage when switching jobs or retiring. When making this transition, people often wonder whether it would make sense to convert one or more 401(k)s into Roth IRAs instead.
Tax rate projection can help determine whether Roth conversion makes financial sense. If your tax rate in retirement will be higher than it is now, converting may make more sense than waiting.
Due to your traditional IRA likely having tax-deductible contributions, it’s essential that you estimate how much of the total amount you want to convert will become taxable income when using the IRS pro-rata rule for taxes on traditional IRA assets. Experts suggest minimizing this tax hit by slowly converting over several years – known as focused conversion.
Are there any fees associated with a Roth IRA conversion?
Roth conversion involves moving pre-tax or tax deferred retirement assets to a Roth account and having it taxed when converted. After being taxed once upon conversion, however, these assets can then be withdrawn at any time without penalty. A financial advisor could help determine if Roth conversion makes sense for you.
Conversions may make sense if income tax rates (personal or corporate) are expected to increase over time. However, it would be prudent not to convert during years when your taxes may be lower than usual as doing so will require you to reduce retirement savings in order to cover any potential tax bills.
Damaryan says the ideal candidate for a Roth conversion would be someone with other assets available to offset any tax liability, or who can use tax credits or losses from past returns to offset it, such as credits or losses from prior years’ returns to reduce it. Otherwise, converting is relatively straightforward: just contact both old and new financial institutions to see what paperwork they require from you before initiating this process.
What are the benefits of a Roth IRA conversion?
Converting to Roth involves paying taxes upfront, but its long-term advantages could outweigh this cost. Furthermore, your Roth IRA won’t be subject to RMDs at age 72 for you or your beneficiaries – something other retirement accounts are.
Roth conversion can bring many advantages, not the least of which being RMDs. Furthermore, assets in your Roth IRA won’t count towards your taxable income at death which makes them an effective estate planning tool.
Roth IRAs offer another great way to diversify retirement savings by investing in assets that don’t defer taxes, thereby helping protect yourself against potential increases in income tax rates in the future. Converting assets over several years allows for gradual payment of tax, reducing overall tax burden while providing more flexibility when paying the bill.