Many retirement savers use traditional IRAs to take advantage of the tax-deferred growth that they offer. But for many, Roth IRAs have even more attractive elements, including tax-free growth that avoids a tax burden when you make withdrawals in retirement. To get those benefits, you can convert your traditional IRA to a Roth.
In this installment of Industry Focus, financials sector analyst Gaby Lapera and Director of Investment Planning Dan Caplinger discuss how Roth IRA conversions work and whether they might be a smart strategy for you to follow. As Dan and Gaby talk about in this clip, if you're in a low tax bracket during any given year, it's a good time to consider a Roth IRA conversion, because the amount you convert gets added to your taxable income in the year in which you make the conversion. Using Roth conversions to get around income limits on contributions to Roth IRAs can also be smart.
A transcript follows the video.
This podcast was recorded on Jun. 6, 2016.
Gaby Lapera: Remember 18-year-old me? I had accidentally opened a traditional IRA. Now I have a Roth IRA with those same funds that I originally opened. And that was a whole heap of a mess, let me tell you, because I opened my IRA right before Bank of America purchased Merrill Lynch. And Merrill Lynch runs all of Bank of America's IRAs. So my IRA fell into some weird dead zone where no one knew how to access it, because it was on Bank of America's servers, but Merrill Lynch was supposed to be managing the IRAs. So converting it was a nightmare. But I did it. Eventually.
I wanted to convert because I realized that I would get tax benefits from a Roth. Are there any other reasons why you might want to convert from a Roth to a traditional, or a traditional to a Roth?
Dan Caplinger: One thing to keep in mind is, the conversion only goes in one direction. If you have a traditional IRA, you can convert it to a Roth, but in general, you can't go back from the Roth. There's a one-time do-over provision that you do have a limited amount of time to undo a Roth conversion. But in general, once you have the Roth, you're going to keep the Roth. And that's generally what you want to do. Again, as we talked about before, once you get that money in the Roth, everything it earns from there on out is tax-free. Tax-free is good. So you want to hang on to that as much as you can.
Now, the deal with the conversion is, there's a couple situations where you'd want to do it. One is, if you're in that situation we just talked about, where your income is above that threshold amount, you're not allowed to make direct contributions to a Roth IRA, you're still allowed to convert a traditional IRA into a Roth IRA. That can be the end run that gets you into the Roth IRA that you would have chosen in the first place if you'd had that direct option. But instead, the IRS said, "You don't have that direct option, but here's this indirect way of getting into it." That works a lot for people who want to get that diversification, who want both a traditional IRA type of fund and a Roth IRA set aside to hedge their bets and have both things available to them.
Lapera: I have a question about that. If you roll a traditional IRA into a Roth IRA, what are the tax consequences of that?
Caplinger: When you do that, the amount that you convert, you're going to have to include that in your taxable income for the year in which you convert it. So, if you did that conversion today, you would take the money that you converted, and then when you file your 2016 tax return next April, that's when you would include that amount as taxable income on that return.
Lapera: Man, am I glad that I rolled it over when I didn't have a lot of money and the government owed me. (laughs)
Caplinger: That's right, that's the time to do it. And that's a good point. If you're in a situation where you have a temporary loss of income -- whether it's because of voluntarily coming out of the workforce, a layoff or some other source of unemployment -- that can be a good time to think about, "If I convert now, I'm not going to have to pay any income tax at all, or might have to pay a small amount of income tax for this." That might be a price that you should be willing to pay in order to get years or even decades of tax-free growth from here on out, from now until when you retire.
Lapera: I think you said you had a couple other scenarios for why you would want to convert.
Caplinger: Yeah. In general, if you find yourself in a situation where you want to control what your taxable income is, then the Roth IRA can be a good way to do that. If you think forward, for instance, there are a lot of situations in retirement where a certain amount of taxable income are going to have implications for other things. For instance, if your taxable income in retirement is too high, then a portion of your Social Security benefits can end up being taxed.
What many people don't fully understand is, with a traditional IRA, once you reach age 70.5, the IRS forces you to start taking money out of your IRA, whether you want it or not, whether you need it or not. The IRS makes you start taking that money out. Because you're taking that money out of a traditional IRA, it is treated as taxable income in the year you withdraw it. If that boosts your income above that threshold amount, it can have Social Security taxation implications as well.
Coming back, what does that have to do with a conversion? If you convert to a Roth IRA earlier in your career, then when you're taking money out of that Roth IRA, first of all, there's no requirement that you take money out of the Roth IRA. But even if you do, it's not taxed, and it isn't treated as taxable income for purposes of your Social Security benefits being taxable, either. So it's kind of an advanced warning system to get your taxes in retirement under control so that you can foresee and minimize your tax bill not just now, but also when you retire.
