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Posted by Tiffany Gaskin

Why Now May Be a Good Time to Convert Your Traditional IRA to a ROTH IRA

Why Now May Be a Good Time to Convert Your Traditional IRA to a ROTH IRA


A well-diversified retirement plan requires more than a variety of investments. Investors should also consider how their savings will be taxed when they retire. Most Americans save for retirement before tax, but retirement income should include some after-tax or Roth savings. Luckily, Roth conversions are available to many people with IRAs, which can save you thousands of dollars in retirement taxes. Read on to learn more about Roth conversions and why now is one of the best times to take action.


What is a Roth conversion?

A Roth conversion allows you to switch from a pre-tax IRA to a Roth IRA, even if your earnings exceed the Roth IRA income limit. By converting a traditional IRA to a Roth account, income tax can be prepaid for tax-free retirement income. This strategy works in two ways because Roth IRAs are not subject to required minimum distributions (RMDs).

Here's a simple example: Imagine you want to convert $50,000 in pre-tax contributions from a traditional IRA to a Roth IRA. You will recognize the $50,000 as gross income, which may be taxed in whole or in part at the marginal tax rate. Upon retirement, the Roth IRA balance, including $50,000 and any income, would not be subject to tax or RMD.

Why convert to Roth? It all comes down to future taxes. If you predict that you will be in a higher tax bracket when you retire than you are now, paying taxes up front through a Roth conversion may be worthwhile. You may be in a higher tax bracket for several reasons, including recognizing large incomes due to high savings rates or increased tax brackets by Congress. Tax rates are continually changing, and current rates are somewhat low compared to the past 90 years. Also, paying taxes upfront on an investment account in exchange for a tax-free raise is a very attractive feature of a Roth IRA.


What's happening in the market?

It's no secret that the market is not doing well right now. Since the start of the year, stock prices have fallen dramatically across various sectors. Traditionally viewed as a foil for stock movement, bond prices also performed poorly in response to the high-interest rate environment. The market is doing poorly whether you're an equity investor, debt holder, or have little of both in a diversified portfolio.


Is it the perfect time for a Roth conversion?

Due to market difficulties, many Americans are surprised by the low balances in their investment accounts. However, these low balances also present an opportunity in the form of Roth conversions. As mentioned above, Roth conversions are taxed based on the cumulative account value. In an era of low account values, the price to become a Roth is also relatively low. Assuming the market has fallen 20%, a Roth conversion can be achieved with 20% less. And those who believe the market will eventually recover can benefit from this tax-free recovery.

A Roth conversion presents an opportunity to diversify their retirement savings while enjoying tax-free growth for many Americans. However, you should always talk to your tax advisor before making a Roth conversion, as they can better assess your situation. Additionally, Roth conversions require tax to be paid in the year of conversion, so potential converts should ensure they have cash on hand to cover this tax liability. A Roth conversion can protect your retirement plan from future higher tax rates and save you some tax liabilities down the road with the right plan.


Is it legal to create a Roth backdoor?

A Roth "backdoor" is just a flippant term for a type of Roth conversion. As smart as it sounds, it's a legit strategy as long as you follow the rules. Backdoor Roth IRAs allow high-income earners to avoid the regular income limits of a Roth IRA by transferring funds from an unlimited income account to a Roth account, thereby avoiding the income limits set by the Roth IRA. However, when you do a Roth conversion in this manner, the funds are still subject to taxes and other IRS rules.


Summary

  • Always consult a tax professional before converting.

  • The market is currently at a discount, as is the price of a Roth conversion.

  • Unlock tax-free growth with a Roth conversion.


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Tiffany Gaskin
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