Are you one of the millions of Americans with retirement money in a traditional IRA? The IRA has long been a popular retirement accumulation vehicle. Many choose to save in a traditional IRA because it may offer tax deductions for contributions, and it allows for tax-deferred growth while the funds are in the account.
Traditional IRAs are also popular choices for those who are switching jobs and need to do something with the 401(k) balance at their former employer. You can roll your 401(k) balance into an IRA without facing any kind of taxes or penalties.
For all the benefits that come with a traditional IRA, there are also some important complications. Primarily, distributions from a traditional IRA are taxable, even after age 59½. While you may benefit from tax deductions upfront and from tax deferral while the assets accumulate, you will face a tax liability on all distributions from the account in retirement.
For many retirees, that’s a problem. They’re already facing a tight budget. The prospect of taxes due to retirement account distributions poses a challenge. They need IRA distributions to support their lifestyle, but they also need to minimize taxes.
The Roth IRA is often an appealing strategy for those who are concerned about taxes. A Roth IRA has tax-deferred growth like a traditional IRA, but it doesn’t offer upfront deductions. Instead, the Roth offers tax-free distributions, which means you can use the account to create a tax-free income stream in retirement.
How do you leverage the tax benefits of a Roth IRA? Through a process called a Roth conversion. It’s a popular strategy for minimizing taxes in retirement. It’s not for everyone, but it may be a strategy that’s worth exploring as you plan your retirement.
How does a Roth conversion work?
As the name suggests, a Roth conversion is simply the process of converting an existing traditional IRA into a Roth IRA. You simply fill out some forms with your account administrator, who then handles the movement of the funds into the new account.
When you close the traditional IRA, you will have to pay taxes on the distribution. For some, this is an aspect of the Roth conversion that isn’t attractive. However, paying taxes today may be a sound strategy if it helps you avoid increased annual taxes in the future.
What other benefits exist with a Roth conversion?
The minimization of distribution income taxes is the primary benefit of a Roth conversion. However, there are other benefits to consider. One is that the Roth, unlike the traditional IRA, does not have required minimum distributions starting at age 70½. That means you can keep your funds accumulating tax-deferred in the Roth as long as you’d like.
Also, Roth distributions are tax-free to your beneficiaries. By converting to a Roth, you could leave a sizable, tax-free legacy for your loved ones. They can take the money in a lump sum or start an income stream that lasts for the rest of their lives.
What should I consider before I convert?
There are a couple of important points to think about before you start the process. One involves the taxes on the traditional IRA. It’s often wise to pay that tax bill with non-IRA funds. You can withhold the taxes from the converted amount. However, to really maximize the tax benefits of the Roth, you’ll want to fund it with as much money as possible. If you pay the tax bill with IRA funds, that reduces the amount that goes into the Roth.
Also, to qualify for tax-free distributions from a Roth, you must be over age 59½, and the Roth needs to have been open for at least five years. If you need to start IRA distributions within five years, a Roth conversion may not be a sound strategy.
Ready to explore a Roth conversion further? Let’s talk about it. Contact us today at Foote Financial Group. We can help you analyze your needs and develop a plan. Let’s connect soon.
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