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Generally speaking, most investors should consider having a Roth IRA as part of their overall retirement plan because it offers federal tax-free growth potential and withdrawals, which have the potential to help minimize taxes and maximize retirement savings.
With a Roth IRA, you contribute money that's already been taxed (that is, “after-tax” dollars). Any earnings in a Roth IRA have the potential to grow tax-free as long as they stay in the account. Withdrawals of earnings from Roth IRAs are federal income tax-free and penalty-free if a five-year aging period has been met and the account owner is age 59½ or over, disabled, or deceased. Roth IRAs are not subject to minimum required distribution (MRD) rules during the lifetime of the original owner, so you can leave your assets in the Roth IRA where they have the potential to continue to grow.
With a Traditional IRA, contributions can be made on an after-tax basis, or a pretax (tax-deductible) basis if certain requirements are met. Any earnings in the Traditional IRA are tax-deferred as long as they remain in the account. Withdrawals of pretax monies are subject to ordinary income tax when withdrawn. Beginning the year in which you turn age 70½, MRDs are required from Traditional IRAs.
For both types of IRAs, distributions before age 59½ may be subject to both ordinary income taxes and a 10% early withdrawal penalty. For a detailed comparison, view the Traditional vs. Roth comparison table.
For many individuals, converting to a Roth IRA may make sense. However, you should consult with a tax advisor and consider the following four factors prior to making your decision:
You cannot convert a minimum required distribution to a Roth IRA. Converting to a Roth IRA will not satisfy your MRD. You will need to take your MRD before you convert.
Since a Roth conversion is a taxable event (in other words, you will have to pay taxes on the amount of money you are converting), when determining how much to convert, you may want to consider how much money you have set aside in nonretirement sources to pay the resulting taxes. You may also want to consider converting to a Roth IRA over a number of years (tax periods) in amounts that will keep the income from the conversion within your current federal tax bracket, or within a federal tax bracket you are comfortable with.
To help maximize your retirement savings, it’s generally a good idea to consider not using the proceeds from the conversion to pay the resulting tax costs. Instead, you should consider using cash or other savings held in nonretirement accounts. Using retirement account funds to pay the taxes will reduce the amount you would have available to potentially grow tax-free in your new Roth IRA. Additionally, if you are under 59½, using funds from your retirement account could result in an additional 10% tax penalty, which may significantly reduce the potential benefit of conversion.
You may be able to convert the following account types to a Roth IRA:
Yes, you can choose to convert an eligible rollover distribution from your old 401(k) directly to a Roth IRA. You will owe taxes on the amount of pretax assets you roll over. Note: If you have assets in a Designated Roth Account (i.e., Roth 401(k)) and would like to roll these to an IRA, you can only do so to a Roth IRA.
The income limit(s) were removed in 2010. However, income limits on Roth IRA annual contributions will still apply. A provision in the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA) allows more people to convert to Roth IRAs by removing the modified adjusted gross income (MAGI) limitations on conversions from a Traditional IRA to a Roth IRA.
You'll owe taxes on the previously untaxed amount of your IRA that's converted. But, unlike Traditional IRA withdrawals before age 59½, there's no penalty involved.
There are a number of factors to consider to help you decide how much to convert. Consider these questions:
It’s generally considered a good idea to use cash from a nonretirement savings or brokerage account to pay the taxes, instead of using the proceeds from the conversion.
You may have the ability to recharacterize (revert) your Roth IRA back into a Traditional IRA. Some reasons for considering a recharacterization include:
You should consult a tax advisor to more fully understand the regulations surrounding recharacterization and conversions.
If you converted an amount from a Traditional IRA to a Roth IRA and subsequently recharacterized that amount back to a Traditional IRA, that amount cannot be reconverted back to a Roth IRA before either the beginning of the calendar year following the calendar year of the conversion, or the end of the 30-day period beginning on the day of the recharacterization, whichever is later. Consult your tax advisor regarding your eligibility to complete a reconversion.
Deciding whether to convert to a Roth IRA is not a simple decision. Before you begin the process, there are things you can do to prepare:
Since 2010, most investors have been eligible to convert to a Roth IRA regardless of income or marital status.
Traditional IRAs (including Rollover IRAs), SEP IRAs, SARSEP IRAs, and SIMPLE IRAs are all eligible to be converted to a Roth IRA (SIMPLE IRA contributions cannot be converted to a Roth IRA during the first two years). Rollover IRAs containing assets from an employer-sponsored plan account are also eligible to be converted. In addition, balances from employer-sponsored savings plans (e.g., a 401(k) or 403(b) plan) that are eligible for distribution and rollover may generally be converted (for example, when you are no longer working for the company sponsoring the plan). Consult your own tax advisor.
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