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Roth IRA Conversion

Is the Roth IRA Conversion right for you?

A revised government tax law makes it easier than ever to convert your traditional IRA to a Roth IRA: The existing $100,000 maximum individual income level for converting a traditional IRA to a Roth IRA will no longer apply. Simply put, this means you can convert your tax-deferred retirement accounts to tax-free accounts by paying taxes at the current rates.

But just because you can, does that mean you should? That answer depends on many factors, including your income tax rate, the length of time you can leave the funds in the Roth IRA without taking withdrawals, your state's tax laws, and how you'll pay the income taxes due at the time of the conversion.

Here are some rules of thumb regarding a Roth IRA Conversion:

  • Generally, you shouldn't convert to a Roth IRA if you would need to hold out some of the IRA money to pay taxes on the conversion. You'll pay a 10% early distribution penalty on the amount you hold out.
  • If your retirement tax bracket will be 15%, avoid paying 25% or higher on your conversion. Remember that a partial conversion may permit you to avoid pushing into a higher tax bracket in the year of the rollover.
  • If your traditional IRA contains mostly nondeductible contributions, converting it to a Roth IRA should produce handsome benefits.
  • Even if all contributions to your traditional IRA were deductible, converting it to a Roth IRA may produce benefits if the first two points above don't apply.
  • SEP and Simple IRAs can be converted as well, if you've been participating in those programs for two years. You'll need to set up a new IRA to receive any additional SEP or Simple IRA contributions after you convert.
  • And don't forget--if you make a Roth conversion and it turns out not to be advantageous, IRS rules allow you to "undo" the conversion (within certain time limits).

Remember, the main reasons you may want to convert to Roth would be that you believe your tax rates when you retire will be higher than they are now, or you believe you can afford the taxes now and are not sure of your ability to pay those taxes when you retire. Consider the following example...

Roth Conversion Example:
You expect your AGI (adjusted gross income) to be $85,000 this calendar year and you want to convert $40,000 of deductible Traditional IRA funds (money you have never paid federal income tax on before) to a Roth. So when calculating your tax liability for the year, your AGI is now $85,000 + $40,000 or $125,000. If your incremental tax bracket is 25%, then you will need to pay an additional 25% of $40,000 or $10,000 in federal income taxes for the year of the conversion.

Therefore, in the context of the example above, if you believe that paying $10,000 in additional taxes now will be more advantageous than paying those taxes at retirement, then the Roth Conversion may be right for you.

Patelco does not offer tax advice. Please consult with your tax professional for tax-related details.

Not sure what to do?

We don't blame you; the Roth Conversion is complex and difficult to understand.

Luckily, the Financial Advisors at Patelco know this process inside and out and can review your finances to see if it's the right move for you. Even better, the advice is complimentary. Find your Financial Advisor and make an appointment today!

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