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How Roth IRA Conversions Could Fit Into Retirement Planning

Retirement Planning
young family of four plays soccer in the park as parents think about benefits of roth ira conversions

Retirement may be just around the corner (or decades away), but it's always the right time to consider your saving options. And for some future retirees, Roth individual retirement account (IRA) conversions are a great fit.

Roth IRAs allow retirement savers to convert some of the money they've invested in a traditional IRA into a Roth IRA. While you have to pay taxes when you make the conversion, this simple move can create financial advantages down the road, especially given that Roth IRA withdrawals are tax-free in retirement.

Learn more about the basics and benefits of Roth IRA conversions, as well as the rules and potential implications they could have for your retirement saving strategy.

The Differences & Benefits of a Roth IRA

The basic difference between a Roth IRA and a traditional IRA is when taxes are paid. With a traditional IRA, the funds you contribute may be tax-deductible for the year you contributed them, but when you retire, any deductible contributions and earnings that are distributed are taxable. With a Roth IRA, you contribute after-tax funds, and when you retire, distributions are not subject to tax so long they qualify (see below). Accordingly, to complete a Roth IRA conversion, you must pay income taxes on the traditional IRA you would like to convert.

With Roth IRA conversions, you can also potentially avoid penalties for accessing cash before retirement age. Paying taxes on income you've earned can be unpleasant at any stage of your life. But it can really sting if you need to access money in your retirement account before you've reached age 59 1/2 and it triggers early withdrawal penalties and taxes, according to the Internal Revenue Service (IRS).

If you've completed a Roth IRA conversion and need to withdraw cash from the account before age 59 1/2, funds you withdraw are tax-free as long as you don't withdraw more than you've contributed or the earnings on your contributions (though these withdrawals may still be subject to a 10 percent early withdrawal penalty tax). If you were to withdraw funds from a traditional IRA before age 59 1/2, you may be subject to a 10 percent early withdrawal penalty along with the regular income tax you owe on the amount withdrawn. And once you've held money in a Roth IRA for at least five years (either because of direct contributions to the account or by way of Roth IRA conversions) and have reached age 59 1/2 or are disabled, you don't pay any tax on the amount you withdraw. (Tax-free withdrawals are also possible when made to beneficiaries of your estate, or if you use the withdrawals to pay for up to $10,000 of expenses when buying your first home.)

Why Convert to a Roth IRA?

A conversion can also help you eliminate surprise tax bills when you're retired. Once you're between the ages of 59 1/2 and 70, you could withdraw from either a Roth IRA or a traditional IRA without the 10 percent additional tax penalty. However, taxes may still apply.

You may qualify for Roth IRA conversions even if you can't contribute. The IRS says that for the 2018 tax year, single filers must have a modified adjusted gross income (MAGI) of less than $135,000 to contribute to a Roth IRA, and the amount you can contribute lowers for those with a MAGI of at least $120,000. Married tax filers must have a combined MAGI of less than $199,000, and their eligible contributions are reduced beginning at $189,000.

There's no income restriction for Roth IRA conversions, however, as long as you complete the transaction and move funds from your traditional IRA to a Roth IRA within a 60-day window, you'll avoid penalties.

Roth IRA conversions can also be used as an inheritance for loved ones when the owner of a Roth account dies. Whoever inherits the money can withdraw it tax-free when they want — and in the amounts they choose.

Roth IRA Conversion Considerations

It's important to note that you'll need cash to pay the taxes you owe on the conversion. One of the main benefits of converting retirement assets to a Roth IRA is to reduce the amount of tax owed when you take distributions from the account in retirement.

However, Roth IRA conversion rules state you must pay taxes on the amount of money you convert in the year you complete the conversion. If you're under age 59 1/2 when you make the conversion and want to use the converted funds to pay the tax you owe, you'll get hit with an early withdrawal penalty. In light of these restrictions, it might be worth considering whether you'll really benefit from a Roth IRA conversion given how much you'll potentially pay in taxes.

You'll also have to guess your future tax bracket with Roth IRA conversions. Roth IRA contributions can be beneficial for younger workers: They'll presumably pay a higher income tax in retirement than at the start of their working lives. It follows that taxpayers who are already in the upper tax brackets might benefit less from Roth IRA conversions, as it's less likely they'll be in an equal or higher tax bracket after retirement.

Roth IRA conversions can provide multiple potential benefits to a retirement savings strategy. But it's important to take your unique situation into account before assuming a conversion is the best move for you.

Related Product
Individual Retirement Accounts (IRAs)

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Information provided is general and educational in nature, and all products or services discussed may not be provided by Western & Southern Financial Group or its member companies (“the Company”). The information is not intended to be, and should not be construed as, legal or tax advice. The Company does not provide legal or tax advice. Laws of a specific state or laws relevant to a particular situation may affect the applicability, accuracy, or completeness of this information. Federal and state laws and regulations are complex and are subject to change. The Company makes no warranties with regard to the information or results obtained by its use. The Company disclaims any liability arising out of your use of, or reliance on, the information. Consult an attorney or tax advisor regarding your specific legal or tax situation.