Should I Convert My Traditional IRA to a Roth IRA?

a couple discussing converting their traditional ira to a roth ira

While converting a Traditional IRA to a Roth IRA makes sense for some investors, it’s not the right move for everybody. Learn more about how these conversions work to consider whether a Roth conversion is the right move for you and your retirement finances.

What Is a Traditional IRA? 

A traditional IRA is a type of individual retirement account (IRA) that allows people to save for their post-work years. Funds are allowed to grow in the account on a tax-deferred basis, meaning the retiree doesn’t need to pay taxes on the funds until they are withdrawn.

A traditional IRA also offers tax benefits up front in the year that contributions are made. Because they were not subject to taxes when they were put in the fund, distributions out of a traditional IRA are taxed as ordinary income when they are received in retirement. The distributions will be penalty-free if taken after the age of 59 ½. 

What Is a Roth IRA? 

A Roth IRA is a type of individual retirement account that allows people to use after-tax contributions to grow tax-free. Investors pay taxes on money going into the account, but the money is not taxed when it is withdrawn.

What Are the Tax Implications of Converting an IRA? 

If you convert your traditional IRA balance to a Roth IRA, you are taxed on the balance of your traditional IRA as ordinary income (assuming that you were always eligible to take tax deductions for your historical traditional IRA contribution amounts). 

However, once you’ve converted an amount to a Roth IRA, all earnings in the account grow tax-free, and distributions may be taken from the account tax-free in retirement. 

When It Makes Sense to Convert to a Roth 

While there’s no one-size-fits-all checklist for you to check off to verify that now is a good time to convert your traditional IRA to a Roth IRA, there are some general fact patterns that make converting your traditional IRA to a Roth IRA more attractive in a given tax year. 

You’re in a Lower-than-Usual Tax Bracket 

If you’re in a lower-than-usual tax bracket this year—perhaps you are taking a year off of work or you lost your job—it might be a good year to do a Roth conversion. 

This is because Roth conversions are taxable at your ordinary income tax rate, and you would obviously rather convert in a year when you are in a lower tax bracket than in a year in which you are in a higher tax bracket. 

In fact, it may make sense for you to only convert a portion of your traditional IRA to a Roth IRA this year up to the upper limit of your current tax bracket so that you won’t have to pay any taxes at a higher tax bracket. 

The Market Is Down 

The amount of income you recognize on your Roth conversion is driven by the value of your traditional IRA on the date of your conversion. 

So, if the market recently crashed, it may make sense for you to take advantage of the dip by converting your traditional IRA to a Roth IRA when the market is low since this will result in a lower tax bill. 

When You Shouldn’t Convert to a Roth 

Similar to knowing when it makes sense to convert to a Roth, there’s no tidy checklist you can mark off to determine that now is definitively not a good time to convert your traditional IRA to a Roth IRA. 

However, there are some general situations in which converting to a Roth IRA may not make sense. For example, if you expect to be in a lower tax bracket in retirement, then the taxes you would pay on a Roth may be greater than with a traditional IRA. In that case, a Roth wouldn’t be the best move. For example, let’s say you’re currently in the 32% marginal tax bracket, but when you retire, you anticipate that you will be in the 12% tax bracket, even taking into account taxable distributions from your traditional IRA. In this situation, it probably doesn’t make sense to take a tax hit at 32% today to save on paying taxes at 12% in the future. 

Of course, no one knows the future, especially when it comes to Congress and tax rates, and the further away you are from retirement, the less likely you will be able to accurately predict future tax rates. 

How to Convert to a Roth 

There are three methods of converting a traditional IRA to a Roth IRA: a direct rollover, a trustee-to-trustee transfer, and a same trustee transfer. 

Converting With an Account Rollover 

When doing a rollover, the company where your traditional IRA is held writes you a check for the amount of your traditional IRA. 

You then have 60 days to deposit the money into your Roth IRA to avoid adverse tax consequences. 

Converting With a Trustee-to-Trustee Transfer 

With a trustee-to-trustee transfer, you tell the company currently holding your traditional IRA to transfer the amount you want to convert to the company holding your Roth IRA. 

Converting With a Same Trustee Transfer 

This is arguably the easiest method of the three. With a same trustee transfer, your traditional IRA and your Roth IRA are held at the same institution. You simply instruct this institution to transfer the amount you want to convert from your traditional IRA to your Roth IRA. 

Should You Convert Your Traditional IRA to a Roth IRA? 

While converting your traditional IRA to a Roth IRA will save you on taxes when you take distributions out of your account in the future, it comes at the cost of a potentially large tax bill today. 

Rather than blindly rushing into this decision, it’s important to consider factors such as your current marginal tax rate, anticipated future tax rates, and how long it will be until you retire and start taking distributions from your IRA. 

Whether you choose to convert your traditional IRA to a Roth IRA or not,a financial advisor can help you consider the full-range of tax-advantaged retirement options available to you. 

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