Those of us with Individual Retirement Accounts (IRAs) are faced with a difficult decision. Should we convert our IRA to a Roth IRA? What are the possible benefits of converting an existing Individual Retirement Account to a Roth IRA? In order to make this decision one must consider, first and foremost, the tax implications of doing so. It would also be helpful to have a crystal ball because making the decision to convert to a Roth should be done with predictions of the future in mind. Whether or not to convert your existing IRA to a Roth IRA can be dumbed down to one simple question: When do you want to pay the taxes to the IRS on your IRA?
Before we look at the advantages and disadvantages of converting to a Roth, let’s begin by understanding the fundamentals of IRAs. An IRA is typically created in one of two ways. First, putting money into an IRA is a way to shield some of your income from taxes. Any contribution you make to an IRA is deducted from the income you report to the IRS for that given tax year. There are limits, of course. The maximum contribution to an IRA in 2013 is $5,500 if you are under the age of 50. For folks age 50 and higher the limit is $6,500. The second way that IRAs are created is by rolling over an existing retirement account. This happens when you are nearing retirement or leave your place of employment where you had a 401(k), 403(b), 457, or other pension or qualified account. Regardless of how your IRA was created, the entire value of the account has never been taxed.
So why does the IRS allow you to put off paying taxes on your IRA? There are two main reasons. First of all, the IRS hopes that your account will perform well over your working years. All of that growth will be taxable when you start withdrawing it during retirement. Secondly, our government provides this tax deferred benefit as an incentive to save for retirement. So what are the basic advantages and disadvantages of converting to a Roth IRA?
When you convert to a Roth IRA, taxes are paid in full on the IRA account at current, known tax rates. No one knows how high tax rates may go in the future so this can be a significant advantage. There’s a flip side to this and it’s known as conversion tax. By converting you are basically adding income to the total income you must report to the IRS. This could, in turn, put you into a higher tax bracket.
Another benefit of a Roth is that at the owner’s death, the account’s beneficiary is not responsible for any income taxes when they draw from the Roth. In addition, retirement income that is withdrawn from a Roth at least 5 years after the conversion isn’t taxable. It should be noted, however, that converting to Roth IRA prior to turning 59 ½ could result in a 10% tax penalty if you do not follow the guidelines set forth by the IRS. It’s always best to consult with a financial advisor when considering any important financial decision such as this.