There are many reasons to open a traditional individual retirement account (IRA). There are no income limits, as with Roth IRAs; nearly anyone can contribute. For most savers, contributions are tax deductible. And if you need the funds early, there are many situations in which the Internal Revenue Service allows penalty-free early withdrawals. Given all the advantages, there’s no reason not to invest any leftover funds you have in a traditional IRA.
However, the other variety of individual retirement account, the Roth IRA, has its own advantages, namely tax-free withdrawals. What if you’ve opened and contributed to a traditional IRA account, but now believe that a Roth IRA may be more to your advantage? Fortunately, the IRS has provided a mechanism for rolling a traditional IRA into a Roth. However, what are the advantages of a rollover IRA vs traditional IRA?
The first thing to bear in mind is, contributions to a regular IRA for most people are tax deductible, whereas contributions to a Roth IRA are not. Therefore, if you want to convert from traditional to Roth, you will owe tax on those contributions, as well as on earnings to date. If you have made tax-deductible contributions to your regular IRA totaling $14,000, and the account now has a value of $20,000 (with $6,000 in dividend and capital gains earnings), you will owe tax on the full $20,000, which will be counted as regular income, in the year that you convert. Many people can’t afford that kind of tax burden in a single year, and spread the conversion over several years.
However, if any of your contributions to your traditional IRA were nondeductible, you won’t owe tax on those contributions when you convert to a Roth. Using the above example, if out of the total $14,000 contributions, $4,000 was nondeductible (perhaps because you didn’t qualify for the deduction during that year), then you will only owe tax on $16,000 — $20,000 minus $4,000.
In deciding whether to roll over your traditional IRA or not, this cost of conversion is the first thing you’ll need to consider. Next is what you might ultimately save when you begin to withdraw. If your $20,000 converted Roth IRA doubles in value to $40,000 before you begin to make withdrawals, you will essentially have $20,000 in tax-free income: you’ve already paid tax on the first $20,000, and you won’t owe on the remainder, as that is the nature of a Roth IRA. If, however, you keep your investment as a traditional IRA and the sum grows to $40,000, you will then owe tax on $40,000, although only gradually, paying tax in a given year only on that amount that you withdraw in that year. (If, in the above example, $4,000 of the total $40,000 amount was a nondeductible contribution, then you still won’t owe tax on that $4,000.)
So you’ll need to do some math, to see whether the conversion is worth it for you. Also consider your current tax bracket, and your expected tax bracket in retirement, when you begin to withdraw funds. If you currently have a high income and pay tax at a 33 percent rate, you’ll owe the same 33 percent on your Roth conversion — and if you make the conversion all in one year, that’s quite a bite. If you anticipate a substantial falloff in your tax rate in retirement — say, to 15 percent — then the taxes due on your regular IRA withdrawals will likewise be taxed at that low rate. You might seriously consider keeping your traditional IRA. If, however, you don’t expect your tax rate to drop in retirement, then converting to a Roth is almost always the best strategy.
One other consideration: if you have a traditional IRA, you must begin making withdrawals after you turn 70½ years of age. Because your withdrawals will be taxable, at whatever the rate, the IRS will want to begin seeing some of that tax revenue. However, there are no required minimum withdrawals from a Roth IRA — because these withdrawals aren’t taxed, the IRS doesn’t care. So if you have other wealth to live on and would prefer the option of keeping your IRA intact, perhaps to pass on to your heirs, then a Roth gives you that option.
There is much to consider between a rollover IRA vs traditional IRA. If you’re finding difficulty in deciding, then seek the assistance of a financial planner or tax accountant. The right decision could save you thousands of dollars or more over the long term.
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IRA calculator helps you decide whether a Traditional or Roth IRA is best suited for your needs.
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