This year marks a change in the law that governs who can and can’t convert a traditional IRA (or 401(k)) to a Roth IRA. In the past, there were income restrictions that prevented people above a certain income threshold from converting. This year, the income restrictions have been removed, and anyone can convert. But should you?
There are some things you’ll want to consider in deciding whether to convert to a Roth IRA:
- How will you pay the conversion tax? Traditional retirement accounts are taxed differently than Roths. Contributions to your traditional account are made with before-tax dollars. So, you don’t pay tax on the money when it goes into the account, instead, you’re taxed when you withdraw funds from the account. Roth contributions, on the other hand, are made with after-tax dollars. Although you pay income tax on your contribution money in the year it goes into the account, generally, all withdrawals including your gains, are tax-free.
To account for this difference, the IRS collects tax at the time you convert your traditional account to a Roth. You want to make sure you have enough funds outside your retirement account to pay for this tax. If you’ll need to make a withdrawal to cover the tax, then a conversion is likely a bad idea.
- Will you be in a higher tax bracket after you retire? Because of the way it’s taxed, a Roth makes sense for those who will be subject to higher income taxes after retirement.
- Do you have a while before you retire? The farther away retirement age is, the more time you have to earn back the money you’ll lay out in paying the conversion tax.
- Do you plan to pass the money in your account on to your heirs, instead of using it for retirement? If you have enough other income and assets to support you during retirement, and plan to use your retirement account to leave a legacy for your heirs, then the tax advantages mean converting to a Roth likely makes sense.