[vc_row][vc_column width=”2/3″ el_class=”section section1″][vc_column_text]The primary reason for many investors to move their savings over to a Roth IRA from a 401(k) or a traditional IRA is due to receiving tax-free income during retirement. This transition is called a Roth conversion.
What some people do not know is that there are other positive motives for making this conversion.
But before we cover that, let’s go over the need to know first.
As mentioned above, Roth accounts give tax-free payments once you are of the minimum age of 59 and a half, where traditional IRA distributions are taxed. Also, with Roth, you do not need to take RMDs (required minimum distributions). Many other accounts, such as 401(k)s and traditional IRAs, once you reach 70 and a half years of age, you must take an RMD.
- Also Read: 3 Reasons Certain Federal Employees Can Retire Years Earlier Than Their Peers Without Penalties
- Also Read: CSRS Retirement in 2024: Are You Making the Most of What This Classic Plan Has to Offer?
- Also Read: Roth IRA Basics for Beginners: What’s There to Learn?
Another thing to consider is that there are income and contribution limits with direct contributions to a Roth IRA. Still, those limits do not apply to funds that are transferred from other retirement accounts that are qualified to do so.
However, Roth conversions may not be for everyone. Depending on your financial circumstances, there may be good reasons as to why you should not do this conversion or why you shouldn’t convert everything you want within a year.
The conversion rules and eligibilities can be a bit complex, so it may be in your best interest to seek out some expert financial adviser to ensure that converting to a Roth would be a good decision for your overall needs and financial situation.
Below are some instances that a Roth conversion may be a good fit.
1. If you are planning to move to a different state, the positive is that the federal rate on taxes will be the same no matter where you decide to go. However, the tax rates at the state level can vary.
While some people retire to a new state with lower taxes or no income taxes to save a good amount of their retirement savings and income, others move for other things such as being closer to family or that they have always wanted to move to that area.
No matter the motive, if you decide to move to a state with a tax rate that is much higher than what it is now, doing a Roth conversion from your traditional IRA or 401(k) would prevent you from facing that higher tax when you receive distributions.
Now, if you end up going to a state that has a lower tax rate or none at all, if you do decide to make a Roth conversion, it may be best to do it once you are in the new state.
2. Another situation that a Roth conversion would be right for is if a married couple expects that one individual may live longer than the other person. That is because if a spouse passes away, the retirement income of the survivor will more than likely be relatively the same. However, the taxes on those “earnings” will be higher for someone that is filing as a single taxpayer as opposed to jointly.
For instance, a married couple that has an income stream of $60K would be under the tax bracket of 12 percent. However, an individual receiving the same amount would be placed within the bracket of 22 percent. Also, the general deduction calculation for an individual is half of what married couples would get.
That big jump in taxes is a crucial matter to consider as to why you may want to convert to a Roth. That way, if there is a surviving spouse, they will receive income that is no longer subject to income tax rather than getting hit with a much higher tax rate.
3. If you are thinking about retiring prematurely, a Roth conversion may make sense. If you were to make withdrawals before the minimum eligible age of 59 and a half, you would be facing a 10 percent penalty.
This not the same for a Roth IRA because direct contributions can be taken out of the account whenever without any penalty. And remember, you already paid taxes on it. However, the money made in that account cannot be withdrawn until the eligibility age as they are subject to the early withdrawal penalty as well as taxes.
For funds that were converted from a traditional IRA or 401(k), you do not need to pay an early withdrawal penalty if you have had the Roth account for at least five years. But just like with direct contributions, you should not touch those earnings until you are at least 59 and a half unless you wish to pay the 10 percent penalty along with taxes.
4. Another situation that a Roth conversion may be ideal is if you have a small business. You can receive a 20 percent deduction on your taxes on what is called “pass-through income,” which is earnings that come from your business through your personal tax return. A Roth conversion can reduce what you may be liable for in taxes.
For those that qualify for that deduction, this deduction will be applied to the taxable income that is less, whether it is your personal income or your business income.
Also, the more taxable income you have, the more deductions you receive.
For instance, let’s say a married couple’s business generates $200K in income, and they decide to file jointly. They end up with taxable earnings of $150K after other eligible deductions.
Now, the pass-through deduction would be applied to the lesser amount, which is $150K. The deduction would be $30,000.
If they chose to convert $50K from a 401(k) to a Roth IRA once they realized the 20 percent would go to the lesser amount, that added income would increase their $150K to $200K, which would give them $40K in deductions. Though this would have the couple’s taxable income of $160K instead of the $120K without the Rother conversion, the difference between the two taxable income is $40K, which means that the $50K conversion was lessened by $10K because of the 20 percent tax break.[/vc_column_text][/vc_column][vc_column width=”1/3″][vc_single_image image=”36278″ img_size=”292×285″ style=”vc_box_shadow”][/vc_column][/vc_row]
