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 you’re 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 aren’t the only factor at play. So you’ll 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 it’s all done correctly.)
Traditional vs. Roth IRAs
Before we dive into conversion factors, let’s 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 they’re made, and all withdrawals are taxed when they’re 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 Roth IRA contributions – but not earnings – can be withdrawn at any time without penalty since you’ve already paid tax on them, so you can access your money when you need to (once you pass the five-year conversion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, you’re required to begin taking RMDs once you hit age 73. With Roth IRAs, you never have to take distributions if you don’t 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 won’t pay any income taxes as long as the five-year rule has been met.
