The
volatility in the stock market may have caused the value of your retirement
account to decrease. But if you have a traditional IRA invested in stocks, a
decline may provide a valuable opportunity by allowing you to convert your
traditional IRA to a Roth IRA at a lower tax cost.
Traditional
vs. Roth
Here
are some key differences between these two types of accounts:
Traditional
IRA.
Contributions to a traditional IRA may be deductible, depending on your
modified adjusted gross income (MAGI) and whether you (or your spouse)
participate in a qualified retirement plan, such as a 401(k). Funds in the
account grow tax-deferred.
However,
you generally must pay income tax on withdrawals. You’ll also face a penalty if
you withdraw funds before age 59½ — unless you qualify for an exception. And
you’ll face an even larger penalty if you don’t take your required minimum
distributions (RMDs) when you
reach age 72 (73 if you reach age 72 after Dec. 31, 2022).
Roth IRA. Roth IRA
contributions aren’t deductible. But withdrawals — including earnings — are tax-free
as long as you are age 59½ or older and the account has been open at least five
years. Plus, you’re allowed to withdraw contributions at any time tax- and
penalty-free and you aren’t subject to RMDs.
However,
the ability to contribute to a Roth IRA is subject to limits based on your MAGI. Fortunately, no
matter how high your income, you’re eligible to convert a traditional IRA to a Roth, but
you’ll have to pay income tax on the amount converted.
Your tax
hit may be reduced
If
your traditional IRA has lost value, converting to a Roth now instead of
waiting could minimize your tax hit. You’ll also avoid tax on future
appreciation if the value of your account goes back up.
Before
converting, take time to think through the details. Here are some key issues to consider:
Money to pay
the tax bill.
If you don’t have the cash on hand to cover the taxes owed on the conversion,
you may have to dip into your retirement funds, eroding your nest egg. The more
money you convert and the higher your tax bracket, the bigger the tax hit.
Your
retirement plans. Typically, you wouldn’t convert a traditional IRA to
a Roth IRA if you expect to retire soon and will start drawing down on the
account right away. Usually, the goal is to allow the funds to grow and
compound over time without any tax erosion.
There
are also other issues that need to be considered before executing a Roth IRA
conversion. If this sounds like something you’re interested in, contact us to
discuss whether a conversion is right for you.
Sidebar:
Stretch out the tax bill
If
the idea of paying the tax bite related to converting from a traditional IRA to
a Roth IRA is daunting, consider a gradual conversion. It’s not an all-or-nothing
process, so you can stretch out the tax bill over time, depending on how long
you expect to wait to retire.
Suppose
you have $100,000 in a traditional IRA. You could, for example, convert that in
five steps: $20,000 per year for five years. We can estimate what the tax bite
will be at varying steps.
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