Converting a traditional IRA involves paying the taxes currently due from the tax deferral of the IRA into the tax-free status of a Roth IRA. The idea behind a conversion is that a little financial pain now will result in significant tax savings in the longer term future. Whether a conversion makes good financial sense depends on each individual's financial circumstances.
Roth IRA Conversion
Converting a traditional IRA to a Roth IRA, changes the status of the IRA from tax-deferred to tax-free. The conversion involves transferring the IRA money from the current IRA to a new Roth-designated IRA. The conversion can be done with your existing IRA trustee or by transferring the money to a new trustee. The amount of IRA money converted becomes taxable income in the year of conversion and will be added to the IRA owner's taxable income for the year.
Pay Taxes Now, Save Later
The concept behind converting an IRA to a Roth IRA is to pay the income taxes now on a smaller IRA balance rather than in the future when the account is worth significantly more money. Consider an IRA currently worth $20,000. Taxes in the 25 percent tax bracket would be $5,000. If the account grows at a 7 percent compound rate for 20 years, the account will be worth almost $80,000. Converting allows the IRA to grow tax-free after you pay the tax on a significantly smaller amount of money.
No Required Distributions
With a traditional IRA, an IRA owner must start making a minimum level of withdrawals from the account starting at age 70 1/2. These withdrawals would be included in the IRA owner's taxable income, increasing the amount of taxes she must pay. With a Roth IRA, there are no required minimum withdrawals. If the IRA money is not needed by the Roth IRA owner, the account can continue to grow tax-free until the money is really needed or it is left to the owner's heirs.
Taxing Social Security
If a retired individual earns a certain level of income, Social Security payments may also become taxable, resulting in a double tax hit on the retired person. This situation could arise if she is taking IRA withdrawals as a portion or her retirement income to supplement Social Security. If the IRA was converted to a Roth IRA, the withdrawals from the Roth are tax-free. These Roth IRA withdrawals would not increase the IRA owner's total income to the point where Social Security income also becomes taxable.
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