A Roth IRA is a special retirement account where you pay taxes on money going into your account but not on money coming out. Withdrawals are TAX-FREE, making them an attractive asset to own in retirement. In contrast, pre-tax savings in a traditional IRA will be TAXABLE when you take money out. This could cost you anywhere from 10%-37% of the account value in the form of income taxes.
While Roth IRAs are becoming more popular, they have been overlooked by many investors. So, if you don’t have any Roth assets or would like more, you can convert a portion of your traditional IRA to Roth. But before you do, here are some questions you should ask yourself…
Question #1: The most basic question of all is “do I want to pay taxes now (Roth) or later (Traditional)?
Question #2: Am I in a lower tax bracket now then I will be in when I withdrawal the money? For most, this will be at retirement. However, since Roth assets can be used for other goals such as your child’s education or purchasing your first home, the answer may not be so simple. Another complicating factor is the uncertainty of where tax rates are going. If you think tax rates are going up, think Roth!
Question #3: Can I afford to pay the taxes due on the converted amount? You will owe Federal income taxes when you convert and that can be painful. Having excess savings helps to alleviate this stressor.
Question #4: What are my goals for my IRA funds? If you don’t think you will spend all of your IRA during your lifetime and plan on leaving this money to your children, Roth accounts are a great asset to pass down to the next generation.
Question #5: Would you like tax-diversification when you retire? My financial planning practice specializes in helping retirees develop an income plan to replace their salaries when they retire. Having a tax-free bucket to pull from really helps!
Question #6: Will higher taxable income increase my Medicare Part B premiums? This is for you retired folks who are over 65 and on Medicare. Medicare premiums are based on your annual income and are bracketed, much like the Federal tax system. If you earn more than a certain amount, your Medicare premium will go up.
Deciding whether you should convert your traditional IRA to Roth can be complicated because there are a lot of deciding factors with taxes being an important variable. Consider the answers to the questions above before deciding to Roth or not to Roth.