4 Questions to Ask Yourself Before a Roth Conversion

Since their inception in 1997, Roth IRAs have been a popular tool for investors, and it’s easy to understand why. Earnings in a Roth IRA can grow tax-free, there are no required minimum distributions, and assets in a Roth can be passed on to beneficiaries free of taxes. Because of these benefits, you may be considering converting your already established IRA into a Roth, but there are a few questions you may ask yourself before a ROTH conversion.

1. Will I need this money in the next 5 years?

When it comes to Roth funds, there’s a five-year rule. In order for Roth earnings to be distributed without any taxes or penalties the funds need to remain in the account for five years. This five-year clock starts on January 1st of the tax year you converted your Traditional IRA to a Roth IRA. If you’re under the age of 59 ½ and decide you need to use your converted Roth earnings, you may be subject to taxes and a 10% penalty.  If you’re over the age of 59 ½ the five-year rule still applies, but you won’t be subject to the 10% penalty.
This rule also applies to beneficiaries. If you pass, and your beneficiary takes a distribution before the five-year mark, they may have to pay taxes on the distribution.

2. Do I have the funds to cover the taxes right now?

You may have to rope your financial advisor in for this one. Because the main difference between a Traditional IRA and a Roth IRA is when the funds are taxed, when you convert from a Traditional IRA to a Roth you have to pay the taxes on the amount you convert.  The tax liability you’ll pay will depend on two things – your income tax bracket and your income tax rate. The taxes could be anywhere from 10%-37%.

3. Do I want to donate any of my IRA to charity?

It isn’t unheard of for IRA owners to leave some or all of their retirement earnings to a charity.  If you’d like to maximize your donation to charity, you may want to think twice about a Roth conversion. Charities typically do not have to pay taxes on IRA distributions, meaning that when you convert your Traditional IRA to a Roth and pay the taxes you won’t be passing the maximum amount of your earnings on to the charity.

4. Do I plan to be in a lower tax bracket when I retire?

Aside from tax rules and potential penalties, this is another factor to consider. Many people fall into a lower tax bracket when they retire because they make less money. While this may not be the case for everyone, it is something to consider in terms of your IRA and its tax benefits.

Prior to retirement, when you’re contributing to your IRA, you’re typically in a higher tax bracket. Roth contributions face taxes so that when you retire, you don’t have to pay taxes on the distributions. Alternatively, Traditional IRA contributions are made with pre-tax funds, meaning the funds are taxed when you take distributions. If you believe you’ll be in a lower tax bracket when you retire, and opt to a Roth, the taxes you pay at the point of conversion may end up being greater than the taxes you would have paid on distributions without converting.

A Roth conversion is a strategy that anyone can use, but it may not be the right strategy for everyone. When planning for retirement, the strategies you use could cost you in the long run.  It’s important to consider all the factors ahead of time and consult a financial advisor.

Ultimately, you get to decide which strategy is best for you. As your self-directed IRA custodian, we are here to support you every step of the way!

Ready to initiate a Roth conversion? Click here to complete and submit our Traditional to Roth Conversion Form.

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