Which is the best way to handle an individual retirement account (IRA)? Let it sit and earn money, then pay taxes on the withdrawals in retirement? Or roll it over to a Roth IRA? Should I pay the taxes now and get tax-free money later? And can I have the taxes due on the rollover taken from the rollover account itself?
-Pat
When youâre thinking about whether to convert a traditional IRA to a Roth IRA, you have more to consider than the immediate tax hit.
While taxes play a big part here, they arenât the only factor at play. So youâll want to look at the full picture as you figure out whether a Roth conversion makes sense for your current and future finances. (And it makes sense to consult a financial advisor before you make this move to ensure itâs all done correctly.)
Traditional vs. Roth IRAs
Before we dive into conversion factors, letâs briefly talk about the differences between traditional and Roth IRAs. Again, most people focus on the tax effects, but there are several other factors that separate the two types of retirement accounts. Those differences make Roth IRAs a winning choice for many people.
Some key differences between traditional and Roth IRAs include:
Tax timing: Traditional IRA contributions are (generally) tax-deductible when theyâre made, and all withdrawals are taxed when theyâre taken. Roth IRA contributions are not tax-deductible, and all withdrawals are tax-free when taken (as long as you follow the rules). That means earnings in a Roth IRA are never taxed.
Easier access to your money: Traditional IRA withdrawals taken before retirement age are subject to 10% penalties on top of the income tax hit. Roth IRA contributions â but not earnings â can be withdrawn at any time without penalty since youâve already paid tax on them, so you can access your money when you need to (once you pass the five-year conversion anniversary).
Required minimum distributions (RMDs): With traditional IRAs, youâre required to begin taking RMDs once you hit age 73. With Roth IRAs, you never have to take distributions if you donât want to.
Reduced taxable income: Traditional IRA withdrawals are subject to regular income taxes, increasing your taxable income. Roth IRA withdrawals are not taxable and not included in taxable income. Lower taxable income can keep you in a lower tax bracket. As an added bonus, it can help you avoid paying income tax on Social Security benefits in retirement.
Tax-free inheritance: Your heirs will pay taxes on withdrawals from inherited traditional IRAs. Heirs taking withdrawals from inherited Roth IRAs wonât pay any income taxes as long as the five-year rule has been met.
For these reasons, many people can benefit long-term from converting a traditional IRA to a Roth IRA. But before you race to make this move, consider the best way to manage it, so you donât end up in financial difficulty. A financial advisor can help.
When to Convert to a Roth IRA
Since you will face a bigger tax bill when you convert a traditional IRA to a Roth IRA, youâll want to do this strategically. If you have fluctuating income, it makes sense to convert more during a lower-income year and avoid conversions in a higher-income year.
You can also convert your traditional IRA in blocks rather than doing it all at once. Youâll need to track multiple five-year anniversaries, but youâll be able to spread out the current income tax burden over several years rather than having to come up with an enormous lump sum all at once.
As for timing, the further away you are from retirement, the better the conversion will serve you. The tax-free earnings in the Roth will have more time to accumulate and accelerate, leaving you with a bigger tax-free nest egg for the future. Consider using this free tool to match with a financial advisor for professional guidance based on your circumstnaces.
When a Roth IRA Conversion Doesnât Make Sense
There are also situations where a Roth conversion doesnât make sense.
For example, if youâre almost ready or already receiving Social Security and Medicare benefits, doing a Roth conversion will increase your taxable income, potentially resulting in taxable Social Security and increased Medicare premiums.
Or if youâre already retired and using the funds in your traditional IRA to cover your living expenses, the current tax hit could make it harder to pay your bills. Another reason to skip this strategy: You donât have enough nonretirement funds available to pay the taxes, which can make the conversion a losing proposition.
The 5-Year Rule for Roth Conversions
Roth IRA conversions come with a special restriction: You canât take penalty-free withdrawals from the Roth IRA before the five-year anniversary of the conversion. And that applies to every conversion separately if you spread it over multiple tax years.
The five-year clock starts at the beginning of the tax year during which you converted the IRA. So, for example, if you converted $25,000 from a traditional IRA to a Roth on Nov. 15, 2022, the clock starts on Jan. 1, 2022. That means you could start taking penalty-free withdrawals after Jan. 1, 2027 â less than five full years from the actual conversion date.
This rule prevents people from doing an end run around the 10% tax penalty for early withdrawals from a traditional IRA. So donât count on taking tax-free withdrawals on your Roth conversion right away.
Dealing With Roth Conversion Taxes
Itâs tempting to use a portion of the rollover funds to pay the taxes on your Roth conversion â but that would be a huge mistake.
Make sure you have enough in regular savings to pay the full tax bill on your conversion.
Any amount you take out of the traditional IRA that doesnât go into the new Roth IRA counts as an early withdrawal. That means, in addition to the regular income tax owed, that money will also be subject to the 10% early withdrawal penalty.
For example, say you want to convert $20,000 from a traditional to a Roth IRA. You estimate the income taxes on the conversion will be $2,000 (or 10% of the total). If you withhold $2,000 from the rollover amount, your Roth conversion will only be $18,000.
The other $2,000 will be considered an early withdrawal ⊠and youâll end up owing an additional $200 in IRS penalties. Plus, your Roth will have less money in it to start, and that means lower tax-free earnings over time.
Consider consulting a financial advisor to make sure your retirement plan makes sense for your goals.
Bottom Line
Donât use part of the conversion funds to pay the taxes. It will cost you penalties now and earnings growth over the long run.
Investing and Retirement Planning Tips
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Consider working with a financial advisor for guidance on how to handle retirement accounts. Finding a qualified financial advisor doesnât have to be hard. SmartAssetâs free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If youâre ready to find an advisor who can help you achieve your financial goals, get started now.
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As you plan for income in retirement, keep an eye on Social Security. Use SmartAssetâs Social Security calculator to get an idea of what your benefits could look like in retirement.
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Keep an emergency fund on hand in case you run into unexpected expenses. An emergency fund should be liquid — in an account that isn’t at risk of significant fluctuation like the stock market. The tradeoff is that the value of liquid cash can be eroded by inflation. But a high-interest account allows you to earn compound interest. Compare savings accounts from these banks.
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Are you a financial advisor looking to grow your business? SmartAsset AMP helps advisors connect with leads and offers marketing automation solutions so you can spend more time making conversions. Learn more about SmartAsset AMP.
Michele Cagan, CPA, is a SmartAsset financial planning columnist and answers reader questions on personal finance and tax topics. Got a question youâd like answered? Email AskAnAdvisor@smartasset.com and your question may be answered in a future column.
Please note that Michele is not a participant in the SmartAsset AMP platform, nor is she an employee of SmartAsset, and she has been compensated for this article.
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The post Ask an Advisor: Help Me Understand the âBest Wayâ to Manage an IRA. Is It Better to Pay Taxes Now or in Retirement? appeared first on SmartAsset Blog.
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