IRA Roth conversion
https://investor.vanguard.com/investor-resources-education/iras/ira-roth-conversion
What is it?
A Roth conversion refers to taking all or part of the balance of an existing traditional IRA and moving it into a Roth IRA.
Why you might convert a traditional IRA to a Roth IRA
First, see the differences between Traditional IRA and Roth IRA.
Enjoy tax-free withdrawals in retirement
When taking withdrawals from a traditional IRA, you’d have to pay taxes on the money your investments earned - and on any contributions you originally deducted on your taxes.
With a Roth IRA, as long as you meet certain requirements, all of your withdrawals are tax-free.
Watch your money grow tax-free for longer
Traditional IRAs force you to take Required minimum distributions (RMDs) every year after you reach age 73*, regardless of whether you actually need the money. So you lose the tax-free growth on the money you had to withdraw.
On the other hand, Roth IRAs don’t have RMDs during your lifetime, so your money can stay in the account and keep growing tax-free.
( Due to changes to federal law that took effect on January 1, 2023, the age at which you must begin taking RMDs differs depending on when you were born. If you reached age 72 on or before December 31, 2022, you were already required to take your RMD and must continue satisfying that requirement. However, if you had not yet reached age 72 by December 31, 2022, you must take your first RMD from your traditional IRA by April 1 of the year after you reached age 73.)
Leave a tax-free inheritance to your heirs
The people who inherit your Roth IRA will have to take RMDs, but they won’t have to pay any federal income tax on their withdrawals as long as the account’s been open for at least 5 years.
A conversion can get you into a Roth IRA - even if your income is too high
The conversion would be part of a 2-step process, often referred to as a “backdoor” strategy.
First, place your contribution in a traditional IRA—which has no income limits. Then, move the money into a Roth IRA using a Roth conversion. But make sure you understand the tax consequences before using this strategy.
Where will you get the money to pay the conversion taxes?
Before you use money from your IRA to pay the tax bill, consider the following:
Short-term consequences
- The money taken out of your IRA to pay conversion taxes would be considered a distribution. This could result in even higher taxes in the year you convert.
- In addition, if you’re younger than age 59½ and you withdraw money from your IRA to pay conversion-related taxes, you could also face a 10% federal penalty on that withdrawal.
Long-term consequences
You’ll lose the chance for that money to compound and grow tax-free in your IRA - which means less money when you need it in retirement.
Other questions to consider
Deciding whether to convert to a Roth IRA hinges on issues like your tax rate now versus later, the tax bill you’ll have to pay to convert, and your future plans for your estate. And remember, the conversion will be permanent - you can’t revert the money back to a traditional IRA.
All or a portion of the money you convert could be considered “reportable income” by the IRS. If you’re on the cusp of the next tax bracket, there’s a chance you’ll get bumped up in the year you convert. To avoid this, consider converting a portion of your traditional IRA (as opposed to converting all of it at once). This could help you:
- Stay out of that higher tax bracket.
- Spread the taxes related to the conversion over a few years instead of getting hit with the entire bill in 1 year.
It’s best to talk with a tax advisor before you make your decision.