The Roth IRA has become an increasingly popular retirement savings vehicle. From 2010 to 2013, Roth IRA balances grew more than 51 percent, while traditional IRA balances grew 28 percent over that same period. In 2013 more than $6 billion was contributed to Roth accounts, while only $4.61 billion was contributed to traditional IRAs.1
The Roth’s popularity stems from its unique tax treatment. You contribute after-tax dollars to your Roth, and the funds grow on a tax-deferred basis. As long as you wait until age 59½ and at least five years after the account was opened to take distributions, all withdrawals are tax-free. That means you can use a Roth to create a tax-free income stream in retirement.
Unfortunately, many people are unable to take advantage of the Roth’s tax benefits. Perhaps your income exceeds the Roth’s limitations and you’re unable to contribute. Or maybe you’ve primarily used a 401(k) or traditional IRA to accumulate retirement assets.
The good news is you can still take advantage of a Roth IRA via a strategy called Roth conversion. As the name suggests, you can use this strategy to convert your traditional IRA funds into a Roth IRA. This strategy isn’t right for everyone, but it can be effective in the right situation.
How does a Roth conversion work?
Under a Roth conversion, you initiate a transfer from your traditional IRA into a Roth. This is usually done through your IRA custodian or through a financial professional. The basic process consists of liquidating the assets inside the traditional IRA and then transferring the funds to a newly created Roth.
It’s important during this step that the funds are transferred directly from the traditional IRA to the Roth and not paid to you. That’s especially true if you’re under age 59½. If the funds are paid to you and you’re under 59½, you may face a 10 percent penalty.
What are the tax consequences?
When you proceed with a Roth conversion, you’re converting a taxable account into an account that generates tax-free income. As you might expect, you have to pay taxes on those funds at some point. That means you will have to pay taxes on the converted amount.
You can have the taxes withheld from the conversion amount. However, it’s often wise to use other assets to pay the income taxes. The best way to maximize the benefit of the Roth IRA is to maximize the amount that’s contributed to the Roth. If part of the funds are withheld for taxes, that limits your contribution.
What are the benefits of converting to a Roth?
The most obvious benefit of doing a Roth conversion is that you’ll avoid income taxes on your distributions in retirement. That tax-free income could help you enjoy more financial stability and live the retirement you’ve always imagined.
Tax-free income isn’t the only benefit, however. Your Roth funds will also be tax-free for your beneficiaries when you pass away. Additionally, you won’t have to take required minimum distributions from the Roth at age 70½, as you do with a traditional IRA.
Ready to explore whether a Roth conversion is right for you? Let’s talk about it. Contact us today at Safe Retirement Strategies. We can help you analyze your needs and develop a strategy. Let’s connect soon and start the conversation.
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