If you want to get the most out of your retirement, a Roth IRA can be one of the best financial tools to consider. With tax-free withdrawal benefits, you can set yourself and your family up for greater freedom and peace of mind in your later years.
Even when you already have traditional retirement accounts, you can still take advantage of all that a Roth IRA offers. We’ll explore how a Roth IRA conversion works and how it can help you benefit the most from your investments.
What Is a Roth IRA Conversion?
A Roth IRA conversion is the transition of a traditional or SIMPLE IRA to a Roth IRA. You can also convert other retirement accounts like Simplified Employee Pensions (SEP) and 401(k)s. By making the conversion, you get different tax benefits than standard retirement accounts.
Benefits of a Roth Conversion
Contributions to a Roth IRA are taxed upfront, whereas a traditional IRA uses pre-tax funds, and disbursements get taxed in retirement.
It’s easy to see the benefits of a Roth IRA when you understand that the IRS wants to get tax money from you no matter what. Since you already give that money to them when you make your contributions, they give you much more freedom with what you do with your money in the future.
Tax-Free Withdrawals
Because you fund your Roth IRA with after-tax money, you don’t have to pay taxes in retirement. One benefit of this is that it protects you from rising tax rates.
It takes careful future planning, but if you expect your income to be higher in retirement than it is now, then a Roth IRA would make even more sense to save you money on taxes. You will pay taxes at a lower income bracket now, and you get to skip what would be a higher tax amount when you make more money in the future.
No Required Minimum Distributions
Many people would be happy to let their IRAs sit indefinitely to earn more interest and perhaps pass on to their heirs. But again, the IRS wants their money, and they make sure you pay up with required minimum distributions (RMDs) once you reach 72 years old.
After you turn 72, you are required to take a minimum percentage out of your IRA, 401(k), and any other retirement account that was funded with pre-tax money. With a Roth IRA, you don’t need to take distributions at any time, and you can let them sit and earn compounding interest as much as you want.
Estate Planning
Since you don’t have to make any withdrawals, a Roth IRA can be a vital estate planning component. You can let your investment sit and grow, and when you pass away, your beneficiaries will get that money in tax-free disbursements.
No Income Limits
If you want the benefits of a Roth IRA, you generally need to fall under a certain income level to fund it. The 2021 Roth conversion rules state that married couples who file jointly must earn $208,000 or less to qualify for a Roth IRA. Individuals need to make less than $140,000.
With a Roth IRA conversion, you aren’t funding a Roth directly but instead converting an existing account to it. And if you make anything higher than the normal income limits, there are no restrictions against doing so.
What Are the Roth IRA Conversion Rules?
A Roth IRA conversion is a straightforward process. First, you open a Roth IRA account and get information on performing a Roth conversion. Then, you’ll work with both your traditional IRA or pre-existing retirement account servicer to get the necessary conversion paperwork.
Making a conversion is a simple series of steps that you may be able to manage directly through your investment portal. When setting up a Roth IRA, you may find it easier to manage conversions if you stay within the same financial institution for all of your accounts.
When you make the conversion, you will have to pay back the taxes on the converted amount that were deducted from the original IRA contribution. You have to report this on the IRS’s Form 8606 for your year-end taxes.
Unlike Roth IRA funds, which are capped at $6,000 for 2021, account conversions can be as large or as small as you want. For example, if you have a $1 million traditional IRA, you can convert $5,000 or $500,000 without issue.
The main point to keep in mind is that the converted amount becomes part of your taxable income, so at a certain amount, your conversion may bump you into a higher tax bracket. It’s best to calculate your annual anticipated earnings and keep your contribution below the amount that would put you into the next tax tier.
The Five-Year Rule
You can withdraw money from your Roth IRA without any penalties or taxes under two conditions — you’re over 59 1/2 years old and you have had the account for at least five years. That five-year rule is critical to remember if you plan on making several conversions.
You can do a Roth IRA conversion at any time, and you can do several in one year. Since you may want to strategically convert less money one year for tax purposes, you could hold onto some funds and convert them the next year. You can even convert them to the same Roth IRA to make it easier to manage.
The problem is, each conversion starts a new five-year waiting period, and you have to keep track of that. For example, if you convert $5,000 in 2021 and $7,000 in 2023, you would only be able to withdraw up to $5,000 in 2026 without being hit with any taxes or penalties.
Is a Roth Conversion Right for You?
A Roth IRA conversion may be the perfect investment strategy for the right person. If you think your taxes will be higher in the future, and you can afford to pay taxes now, then a Roth IRA conversion is worth investigating. When you make the switch, you could create a world of possibilities for your future.
If you’re ready to have the Roth conversion talk, our agents at My Guaranteed Income are here to answer your questions. Contact us today to learn more about how we can help you find personalized plans to meet your retirement goals.
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