As many companies begin to phase out their pension plans, people are taking a closer look at their options for personal retirement saving. Individual retirement accounts (IRAs) and Roth IRAs are common forms of retirement saving, each with its benefits. Converting a traditional IRA to a Roth IRA may convey tax advantages for some individuals. Doing this type of conversion is relatively easy, though it is important to carefully consider potential costs before doing so.
The main reason that a person would want to convert a traditional IRA to a Roth is to save money on taxes. Future tax rates are hard to predict, but if a person thinks that his tax rate will be higher at retirement than at present, it may make sense for him to switch his IRA to a Roth. Since withdrawals from a Roth are not taxed, and contributions to a traditional IRA are done with pre-tax dollars, doing a “rollover” from one type of account to the other may sound ideal. However, the conversion itself incurs a tax liability, significantly complicating the process.
Contributions to a traditional IRA that were originally tax-deducted will be taxed when the conversion to a Roth takes place. If the account has earned capital gains, these will also be taxed. Depending on the tax laws at the time of the conversion, it may not be able to take place at all. For example, some laws prevent individuals with an adjusted gross income of over $100,000 US Dollars from converting to a Roth.
Care must also be taken to avoid accidentally being pushed into a higher tax bracket by the conversion. This can often be done by spacing the conversion out over more than one year. Doing this ensures that what computes as a sudden financial windfall does not affect the conversion in a way that it would no longer make financial sense.
Since a rollover is considered a “qualified” reason to withdraw from an IRA, meaning it won’t be subject to the usual 10% penalty, the conversion is a very simple process. It basically consists of liquidating the IRA and establishing a Roth IRA in its place. A Roth can be opened through any willing financial institution, such as a bank, mutual fund company, or insurance company.
Once the necessary forms are filled out and the account is funded, the Roth can grow and be used tax-free. When the Roth is established, it is important to determine who will receive it in the event of the death of the account holder. It may make sense to consult an estate planning professional for this step, especially since Roth IRAs can be inherited tax-free.