When to consider making a Roth IRA conversion

If you’re not sure if a Roth IRA is for you, consider some of these tax advantages.

by. Kelly Campbell

For individuals who have large government or military pensions and/or Social Security payments that will place them in high tax brackets, the idea of receiving a portion of your retirement income tax-free is very appealing. For people fortunate enough to be in these situations, the Roth individual retirement account should be at the top of their financial “to-do lists” because the tax savings over a number of years can be significant. If you have not already established a Roth IRA and will have a guaranteed retirement income greater than $50,000 per year, then you want to do a conversion before April 15. Here’s why:

Taxes, taxes, taxes. Unless your retirement income is coming from a Roth IRA or a permanent life insurance policy, you will likely be subject to ordinary income taxes on any distributions from a traditional IRA, 401(k) or pension. Most folks assume that they will be in a lower income tax bracket during their retirement because their expenses will go down once they do not have additional costs associated with their preretirement lifestyle. Unfortunately, this is not always the case, and even when it is, a 15 percent decrease in spending does not always mean that your income drops into a lower tax bracket. Remember, you lose valuable deductions in retirement, such as 401(k) contributions, and many retirees have contributed significant funds to paying down their mortgage, leaving a smaller mortgage interest deduction to be taken. Add up your pensions and Social Security benefits before you go to file your taxes this year. Take these numbers to your CPA for a “projected” tax obligation in retirement with a lower spending figure and fewer deductions. The result may surprise you.

Put your gains to use. The biggest drawback to converting a traditional IRA into a Roth IRA is the tax bill that goes to the Internal Revenue Service for your privilege to do so. Remember, any amount that is converted is essentially additional income that you earned for the year. Therefore it is subject to ordinary income tax. This can have a significant impact on your tax bill, so you’ll want to work closely with your CPA and financial advisor when doing so. However, given that the stock market continues to chug along and raise the value of people’s portfolios, this could be a good opportunity to take some of the gains from your winning positions to pay for the cost to convert your funds to a Roth IRA. Have your advisor evaluate which positions have had the biggest increases in the past few years and determine if it’s appropriate to sell those shares and funds to get into other opportunities. The money will still be invested for retirement purposes, but rebalancing your portfolio on a regular basis is critical to successful investing. The gains from your winning positions could be reinvested in more lucrative opportunities within a Roth IRA, giving you the benefit of tax-free distributions, potentially from a larger asset base.

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