Since its inception in 1974, the individual retirement account (IRA) has become one of the most popular vehicles for saving for retirement. There are more than 25 million IRAs in the United States, and they hold more than $2.4 trillion in assets.1
While there are several different types of IRAs, one of the most commonly held is the traditional IRA. The traditional IRA is the first type of IRA that was introduced, and it’s long been favored because of its tax advantages. Specifically, you can take tax deductions for your upfront contributions and enjoy tax-deferred growth as long as the funds stay in the account.
In recent years, though, the Roth IRA has grown in popularity. While the Roth also allows for tax-deferred growth, it doesn’t offer upfront deductions. Instead, with a Roth, you can take tax-free distributions as long as you’re over age 59½ or disabled. For many, the prospect of having a tax-free income stream in retirement is too appealing to pass up.
But what if you already have most of your retirement funds in a traditional IRA? How can you leverage the tax-free income potential of a Roth? Fortunately, you can take advantage of a strategy known as a Roth conversion. It’s not for everyone, but for some retirees it can be an effective way to minimize tax exposure in retirement.
What Is a Roth Conversion?
As the name suggests, a Roth conversion is simply the process of moving traditional IRA funds into a Roth IRA. It’s usually as simple as filling out some forms with your IRA custodian. The custodian handles the actual transaction of moving the money between accounts. The funds never actually touch your hands.
An important note to realize is that you do have to pay taxes on the amount that’s converted out of the traditional IRA. This can make for a substantial tax bill for the year in which you do the conversion. You should analyze this point and make sure you can afford to pay those taxes.
However, the tax payment may be worth it if it gives you tax-free income in the future. That’s especially true if you don’t need income right away and can allow the funds in the Roth to accumulate for a bit. Then you can enjoy tax-deferred growth followed by tax-free distributions.
Other Benefits to a Roth Conversion
The tax-free income is the primary reason most people do a Roth conversion, but there are other benefits. One is that, unlike a traditional IRA, a Roth IRA doesn’t require minimum distributions at age 70½. That means you can keep your funds in the Roth as long as you’d like and continue growing your assets tax-deferred.
Also, Roth distributions aren’t just tax-free for you—they’re also tax-free for your loved ones. Your beneficiaries can take the funds as a lump sum or convert their share into a tax-free income stream. A Roth IRA could be a great way to leave a tax-advantaged legacy for those you love the most.
As mentioned, a Roth conversion isn’t for everyone. There are many points to consider before moving forward. The tax payment is especially important to review. However, it could be an effective way for you to maximize your income and your financial stability in retirement.
Curious to learn more about Roth conversions? Let’s talk about it. Contact us today at Legacy Retirement Services, so we can help you analyze your needs and develop a plan. Let’s connect today.
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16295 - 2016/12/19
Terry L. Tyler