By Lee Sherman
One of the surest ways to maximize your retirement income is to limit your tax burden by paying those taxes now versus later when you may be in a higher tax bracket. Taking all or part of the balance from your traditional IRA and moving it into a Roth IRA can let your money grow tax free for use by you in retirement or to pass on to your heirs.
It’s important to understand the differences between the different types of IRAs and how they can affect your retirement plan. With a traditional IRA, while you typically get a tax deduction on your contributions, you have to pay taxes when you withdraw the money in retirement.
A Roth IRA is a retirement account that allows you to pay taxes up front on any money going into your account. All future withdrawals are tax-free. For most people Roth IRAs make sense because, if you’re doing it right, you will be in a higher tax bracket when it comes time for retirement. Your taxes could go up because of changes to the tax code or because you’re earning more. A Roth IRA is a long-term strategy that can save you a lot in taxes.
Normally to be eligible for a Roth IRA, your modified adjusted gross income must fall below a certain limit. In 2020 that limit, for someone who is married and filing jointly is $206,000. If you’re single, the cutoff is $139,000. But, if you’re a wealthy investor that may not be eligible for a Roth IRA, you still might be able to do a Roth IRA conversion, by moving the money from a traditional IRA to the Roth.
The benefits of a Roth Conversion
Tax-free withdrawals in retirement. When you withdraw from a traditional IRA, you pay taxes on the money that your investments have earned and on any contributions you may have deducted originally. With a Roth IRA, your withdrawals are tax free as long as you meet the requirements for when you can rollover the money. Note that these have changed following the passage of the CARES Act of 2020 (passed for COVID-19 relief) so you’ll want to go to irs.gov or check with your tax advisor to understand how you’re affected.
Grow your money tax-free. With a traditional IRA, you must take a required minimum distribution (RMD) every year after you reach age 72 (age 70 1/2 if you hit age 70 1/2 before 2020). The CARES Act provides a temporary exception, waiving any RMDs for 2020.
But Roth IRAs don’t have the distribution requirement at all, allowing you to leave the money in your account where it can continue to grow tax-free.
Leave a tax-free inheritance. The real beauty of a Roth IRA is that you won’t leave your heirs with the huge tax burden they could face should you leave the money in a traditional IRA. They won’t have to pay any federal income tax on those withdrawals as long as you’ve had the account for at least five years.
Whether or not converting to a Roth IRA is right for you depends mainly on what your tax rate is now and what you expect it to be later. But doing the conversion means you better be prepared to incur a hefty tax bill. And remember, this is a one-way trip. Once you’ve moved your money into the Roth IRA, you can’t go back to a traditional IRA.
Lee Sherman is a contributing writer to MyPerfectFinancialAdvisor, the premier matchmaker between investors and advisors. Lee is an experienced journalist and editor with over 30 years of expertise with a significant history of writing in the personal finance and technology arenas.