The Benefits of Converting to a Roth IRA

November 11, 2015

converting to a Roth IRATraditional IRAs and retirement plans sponsored by employers are great retirement investment tools.  While there are benefits associated with these types of retirement accounts, Roth IRAs may have additional benefits as well.  You can choose to either transfer all or some of your existing retirement account to a new Roth IRA, and you can do so without regard to your income.
Differences in Tax Incentives between Traditional and Roth IRAs
Traditional IRA contributions are tax deductible during the year you make the contribution. However, withdrawals from a Traditional IRA, during retirement, are taxed at the ordinary income tax rates.  In other words, by contributing to a Traditional IRA you can defer taxes until you are required to take distributions.  This allows for tax-free growth of your retirement funds for years, or even decades.  Roth IRAs do not provide a tax break on contributions, but instead the earnings and withdrawals are tax-free. So, you can avoid taxes when you contribute to a traditional IRA, while you avoid taxes when you withdraw from a Roth IRA during retirement.
Can I contribute to a Roth IRA?
Each type of IRA or retirement account has its own eligibility requirements, based on certain income limits.  Anyone with earned income who younger than 70 ½-years-old, can make contributions to a Traditional IRA.  A Roth IRA, however, only allows full contributions if the individual’s income is below $116,000 for an individual ($193,000 for a married couple filing a joint tax return).  “Earned income” refers to the money an individual is paid to work, which includes wages, salaries, tips, bonuses, commissions, and self-employment income.  Many people cannot contribute to a Roth IRA due to income limits, and are forced to put their retirement savings into Traditional IRAs or another employer sponsored plan (such as a 401(k)).
Why should I convert?
If there is a likelihood that your income tax rate will increase, then converting to a Roth IRA should be a serious consideration.  When your earnings are currently too high to qualify for making contributions to a Roth IRA, you can accomplish the same goal by converting to a Roth IRA instead.  Converting to a Roth IRA means you must pay the income taxes now, but you can enjoy tax free retirement income when you withdraw retirement funds in the future – an obvious benefit.  One consideration, though, is whether the amount you plan to convert, when coupled with your current year’s income, will create a significant tax burden.  If the conversion will cause you to be placed in a higher income tax bracket, or subject you to unnecessary taxes, then you may want to reconsider.
How the conversion is made
The easiest way to convert a retirement account to a Roth IRA is to make a direct trustee-to-trustee transfer between financial institutions.  Or, if you keep the retirement account at the same investment firm, you would simply request that your traditional IRA is re-designated as a Roth IRA.  That way you do not need to open a new account.  You do not need to convert all of your Traditional IRA at one time; this process can be stretched out over a number of years to minimize the taxes you have to pay upon conversion.  Furthermore, if it turns out that converting during one year was a bad financial decision, there are ways in which you can reverse the conversion and put the funds back into your Traditional IRA to be converted in a future year (note, however, that there are very strict timing requirements for this rollback).
If you are issued a check by your financial institution, you must withhold 20% of the amount for tax purposes.  As long as you deposit all of the funds, including amount withheld, into the new Roth account within 60 days, you will not incur any penalty.  Otherwise, you may be subject to a 10% early withdrawal penalty, if you are younger than 59 ½.  The penalty will be imposed in addition to the income taxes you already owe on the entire converted balance.
If you have questions regarding Roth IRAs, or any other retirement planning needs, please contact Anderson, Dorn & Rader, Ltd., either online or by calling us at (775) 823-9455.

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