Time now to transfer to Roth IRA
If you are reading a headline that states now is the time to convert your IRA and wonder what it means, allow me to explain.
When you convert your traditional IRA to a Roth IRA, you must pay taxes on the entire amount. If you are invested in the market, you already know your traditional IRA this year has gone down 30%. If you respond that yours did not go down 30%, you are either extremely lucky or more likely not in the equity market. Simply said: You have less money now, so you would pay less taxes.
For example, $100,000 in the market on Dec. 31, 2021, is now worth $70,000 today. If you converted your traditional IRA on Dec. 31, 2021, and are in a 30% tax bracket you may owe $30,000 in taxes. Converting today, you would owe $21,000, in taxes, a savings of $9,000.
Now let me be clear: This is a timing issue, not a reason to convert.
A key benefit of doing a Roth IRA conversion is it can lower your taxes in the future. While there’s no up-front tax break with Roth IRAs, your contributions and earnings grow tax-free. In other words, once you pay taxes on the money that goes into a Roth IRA, you’re done paying taxes, provided that you take a qualified distribution. While it’s impossible to predict what tax rates will be in the future, you can estimate if you’ll be making more money and, therefore, be in a higher bracket.
Another perk to a Roth IRA is that you can withdraw contributions (not earnings) at any time, for any reason, tax-free. Still, you shouldn’t use your Roth IRA like a bank account. Any money that you take out now will never get the opportunity to grow. With this in mind, remember it is best to have other money to pay the taxes if you decide to convert.
Moving to a Roth IRA also means that you won’t have to take required minimum distributions (RMDs) on your account when you reach age 72. If you don’t need the money, you can keep your money intact and pass it to your heirs.
The largest disadvantage of converting to a Roth IRA is the large tax bill. Convert enough and it could even push you into a higher tax bracket.
When you do a Roth IRA conversion, you risk paying that big tax bill now when you might be in a lower tax bracket later. While you can make some educated guesses, there’s no way to know for sure what tax rates (and your income) will be in the future.
Also be careful if you convert one IRA and have other traditional IRA’s, SEP, or SIMPLE IRA balances elsewhere. When this happens, you’re required to compute a ratio of the money in these accounts that have been taxed already vs. the aggregate balances that have been taxed already vs. the aggregate balances that have not been taxed (in other words, all tax-deferred account balances for which you didn’t). This percentage is counted as taxable income.
If you’re younger, you must keep the funds in your new Roth IRA for five years and make sure that you’ve reached age 59½ before taking out any money. Otherwise, you’ll be charged not only taxes on any earnings but also a 10% early distribution penalty – unless you qualify for a few exceptions.
Converting from a traditional IRA to a Roth is complicated; fortunately there is professional help. Reach out to your tax adviser and financial adviser to help you decide and work through the process.
Bob Hollick is a State Farm Insurance agent based in Washington. His column appears every other Friday in the Observer-Reporter.