Converting a traditional IRA to a Roth IRA is all about tradeoffs. Your tax bracket – now and in the future -- and your age may be key determining factors. How long you want to keep funds in an IRA can come into play as well. Understanding the rules and tradeoffs is your first step in making the decision.
You contribute to a traditional IRA in “pre-tax” dollars, meaning you are able to subtract the contribution from your income before tax is calculated. Thus contributing to a traditional IRA reduces your tax liability in the year of the contribution. When you withdraw funds from a traditional IRA, they are subject to taxation as ordinary income. You must take minimum annual withdrawals determined by dividing fund totals by IRS life expectancy tables starting at age 70-1/2 to avoid a substantial penalty. You cannot make any contributions into a traditional IRA after you reach 70-1/2. The biggest advantages to a traditional IRA are that the initial contribution is a tax deduction and the withdrawals might be taxed at lower levels, assuming either lower tax rates or lower income or both at your retirement.
You contribute to a Roth IRA in “after-tax” dollars. However, neither the contributions nor earnings are subject to tax when you withdraw funds from the account. You can continue contributing to a Roth IRA for as long as you live and there are no withdrawal requirements. The chief advantages of a Roth IRA, then, are that the earnings are tax-free and you are not required to make withdrawals at any time. Because IRAs of all types may be inherited, a Roth works particularly well for heirs because it can continue growing tax-free after your death.
The IRS allows you to convert all or part of a traditional IRA to a Roth IRA. In doing so, the entire amount you convert will be taxed at your ordinary income rate. This is because your original contribution was pre-tax – you subtracted that amount from your income in the year or years you made the contribution and because all earnings in a traditional IRA are subject to tax. However, once you convert to a Roth, future earnings will not be taxed and all Roth rules rather than traditional IRA rules will apply.
When it Makes the Most Sense
You can only know whether it makes sense to convert when you compare both scenarios – keeping your traditional IRA and converting. You will notice in this process that there is a tradeoff between paying taxes now on the conversion and not paying any tax on the withdrawal later. If you are still young – say, under 40 – converting to a Roth is probably a no-brainer. A $10,000 investment at 5 percent interest compounded annually will amount to almost $34,000 in 25 years. In a Roth, the $24,000 in growth, along with the original contribution, will be tax-free. In an IRA, that amount plus the original contribution will be taxable. While no one can say what taxes will be like in 25 years, it’s unlikely they would be nonexistent, which is what they would have to be to make an argument against conversion. The one thing you will have to plan for in advance is paying taxes on the money subject to conversion.
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