If you currently have a traditional IRA, you may be considering whether you should convert your IRA to a Roth IRA. The answer to that question, like most tax questions is… “it depends…”. Let’s first take a look at the difference between a traditional IRA and a Roth IRA. The main difference between the two is the timing of the income tax paid on the distributions. With a traditional IRA, your eligible contributions are deductible on your tax return, but distributions of both contributions and earnings are taxable when you withdraw them. With a Roth IRA, your contributions are nondeductible but qualified distributions of both contributions and earnings are tax-free if you meet certain requirements.
Typically, from a tax perspective, a Roth IRA works out better if you expect your tax rate to be higher when it comes time to withdraw the funds. That’s because you pay the tax up front when your tax rate is lower. Also, a Roth IRA becomes more advantageous when you have a long time period from when you make contributions and expect to withdraw the funds. This is because the earnings generated by your Roth IRA are tax free when you withdraw the funds.
Estate planning benefits
From an estate planning perspective, a Roth IRA has two very important advantages. First, unlike a traditional IRA, a Roth IRA does not mandate required minimum distributions beginning at age 72. You can allow the funds in a Roth IRA to continue growing tax-free for the rest of your life, significantly increasing the amount available for the beneficiaries of your estate. Second, upon passing, your children or other beneficiaries can withdraw funds from a Roth IRA tax-free. Unlike a Roth IRA, an inherited traditional IRA will be taxable to the beneficiaries.
Timing is important
Converting a traditional IRA to a Roth IRA will most likely result in taxable income in the year the conversion is made. It is important that your tax advisor consider this additional income into your tax strategy for the year of conversion. Typically, a tax year in which you expect to have a lower amount of taxable income is often a great time to consider a Roth conversion. This allows you to take advantage of a year with lower tax rates than you may have in future tax years.
If you’re contemplating a Roth IRA conversion, discuss the costs, benefits and potential risks with your ClarkSilva team member today. 401-702-0070.