When retirement funds are transferred from a traditional IRA or 401(k) into a Roth account, the event is called a Roth IRA conversion. Here’s what you need to know about the benefits, limitations and tax impact of Roth IRA conversions.
What is a Roth IRA?
One big differentiator between a Roth IRA and a traditional IRA is when taxes are paid. For traditional IRAs, contributions are pre-tax and taxes are assessed at the time of disbursement. On the other hand, contributions to Roth IRAs are deposited after tax. Because taxes are paid before investing funds in a Roth IRA, taxes do not need to be paid on later disbursements.
What are the benefits of a Roth IRA Conversion?
A Roth IRA allows for tax-free withdrawals of qualified distributions. A Roth IRA conversion may be a great financial strategy for individuals with large traditional IRA accounts who want to plan ahead for tax implications. The ideal candidate for a Roth IRA conversion may expect future tax bills to maintain or increase, and would prefer to pay taxes sooner rather than later.
Because of the tax implications, Roth IRAs are often utilized as a good estate planning tool for individuals who would like to leave a tax-free legacy to their heirs. Qualified distributions are tax-free to both the account holder and the beneficiary of a Roth IRA account.
Are Roth IRA investment gains taxed?
Another benefit of a Roth IRA: certain investment gains are tax-deferred, and you can withdraw investment gains tax-free if certain requirements are met. To benefit from tax-free gains, the account should be open for a minimum of five years plus one of the following trigger events has occurred:
- The IRA owner is age 59½ or older
- The IRA owner can’t do any substantial work due to a disability
- A withdrawal (up to $10,000) is used for first-time home-buying expenses
- The IRA owner has died
What are the limitations of a Roth IRA Conversion?
A Roth IRA conversion creates a taxable event. Therefore, income tax must be paid on the funds at the time of conversion. It’s important to consider the tax ramifications, including the current tax rate versus anticipated future tax rates. When considering a Roth IRA conversion, also consider your anticipated tax bracket at the time of the conversion versus retirement. It’s advisable to pay any resulting conversion taxes in cash, therefore an accurate estimate of potential taxes owed should be generated when considering a conversion. It’s important to carefully weigh the pros and cons of initiating a Roth IRA conversion before taking action, as a Roth conversion cannot be reverted back into a traditional IRA.
Wickham Financial & Insurance Services works closely with our clients to understand the essentials of their financial needs. Contact one of our financial advisors to learn how we can work together to maximize your retirement savings.
Any information provided has been prepared from sources believed to be reliable but is not guaranteed, does not represent all available data necessary for making investment decisions and is for informational purposes only.