Roth Conversions: What You Need to Know

If you’ve ever discussed investment options with a professional, chances are a Roth IRA has come up.

What is a Roth IRA?

Simply put, a Roth IRA is a retirement savings account that allows your money to grow tax-free.  That means you’ve already paid taxes on the money you put into that savings account, so when you start to withdrawal at retirement, you pay no taxes on that money.

What is a Roth Conversion?

This is where things get a little more complicated.  Not everyone meets the IRS standards to contribute to a Roth IRA, largely because their incomes exceed the Roth IRA income limits.  That’s where the Roth Conversion comes in.

Many individuals who don’t qualify for a Roth IRA end up investing in 401(k) plans and Traditional IRAs.  When you have a Traditional IRA, you received a tax break at the present moment, but pay income taxes in retirement.  The IRS has always allowed some individuals to convert their Traditional IRAs to Roth IRAs as long as they met certain qualifications and paid income tax on the conversion. 

High-income earners were not eligible for this conversion until recently.  Thanks to recent changes made to the IRS rules, there is no longer an income cap in place (previously, your income needed to be under $100,000) to convert from a Traditional IRA to a Roth IRA.  Those individuals can now convert as long as they pay the appropriate tax on the conversion.  The taxable amount that is converted is added to your income taxes and your regular income rate is applied to your total income.  If the amount is large enough, it may raise your tax bracket for the year in which you do the conversion. This entire conversion process is what’s known as a “backdoor” Roth IRA.

There is also no longer a 10 percent early withdrawal penalty if the funds move from a Traditional IRA to a Roth IRA, as long as it is within a 60-day window.

You should also note that if the money in your Traditional IRA is post-tax money (meaning you did not take a deduction on the money you contributed), you may not owe tax when you convert to a Roth IRA.  This is something you need to discuss carefully with your financial advisor.

How will a Roth Conversion benefit me?

Taking advantage of the benefits a Roth Conversion offers makes it well worth considering.  Here are just a few of those benefits:

  • Withdrawals are tax free. While you’d have to pay taxes on any withdrawals you make on a traditional IRA, all of your withdrawals are tax-free with a Roth IRA (that is, as long as you meet certain requirements).
  • No RMDs. With a traditional IRAs, you must make required minimum distributions (RMDs) every year after you reach age 70 ½, regardless of whether you actually need the money. Roth IRAs do not have RMDs, so your money can stay in the account and continue to grow tax-free for as long as you need.

Last but not least, if a Roth Conversion is something you’re thinking about doing, now is the time.  Today’s federal income tax rates are the lowest they’ve been in some time, and if you do a conversion in 2019 you’ll pay today’s tax rates on the extra income triggered by the conversion.  What’s more, you’ll avoid the potential for future, higher rates on all the post-conversion income that will be earned in your Roth account.

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