Roth IRAs are appealing because you don't have to pay taxes on your distributions in retirement since you paid taxes on your initial contributions. You also don't have to take any required minimum distributions when you turn 70 1/2 like you do with every other type of retirement account.
If you don't have any Roth accounts, there is still time to take advantage of these benefits by opening a new Roth IRA or doing a Roth conversion, where you move money from tax-deferred retirement accounts into a Roth IRA. However, this isn't always the wisest move. Here are a few things you need to know before doing a Roth conversion.
1. You have to pay taxes on the converted amount in the year of the conversion.
Traditional IRAs and most 401(k)s are tax-deferred, which means the amount you contribute reduces your taxable income that year. Then, when you withdraw the money in retirement, you must pay taxes on your distributions. When you're doing a Roth IRA conversion, you're switching from tax-deferred growth to tax-free growth. And you can't do that without giving the government its cut.
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The money you convert gets added to your taxable income in the year you complete the conversion. Depending on how much you earn this year and how much you're converting, this could push you into a higher tax bracket. Then, you could end up paying more than you expected in taxes. And the real kicker is that since you can't use any of the converted funds to help you pay this tax bill (you'll incur a penalty if you access these funds under age 59 1/2), you need to be sure that you have enough savings to cover the extra taxes on your own.
2. It isn't always the smartest move.
Contributing to a Roth IRA makes sense if you believe you're in the same or a lower tax bracket now than you think you will be in retirement. In that case, by paying taxes now, you'll lose a smaller portion back to the government than you would if you waited until retirement to pay. But if you believe you're in a higher tax bracket now than you will be in retirement, contributing to a Roth IRA or doing a Roth conversion isn't a wise decision.
You'll pay taxes on the money at your current tax rate and you'll end up giving away a larger amount than you would have had to if you'd kept the money in your tax-deferred retirement account and paid taxes on your retirement distributions.
3. You can still do a Roth conversion even if you're over the Roth IRA income limits.
There are restrictions on how much high-income earners can contribute to a Roth IRA. In 2019, single adults making $137,000 or more and married couples making $203,000 or more are not allowed to contribute to a Roth IRA at all. But they are still allowed to do Roth IRA conversions. This is called a backdoor Roth IRA.
You can contribute as much as you'd like to your traditional retirement accounts, up to the annual limit. Then, you do your Roth IRA conversion, pay your taxes, and the money is allowed to grow tax-free after that. It's like having a Roth IRA, except you need to jump through a few more hoops. But as I mentioned above, it's important to make sure that a Roth IRA is the best place for your money before opening one. If you're earning six figures, chances are that you'll probably be in a lower tax bracket in retirement, so traditional retirement accounts may make more sense, unless you expect your high income to continue into retirement.
4. You can't reverse your decision.
As of 2018, Roth IRA conversions can no longer be undone. So, it's important to make sure that you're comfortable with the decision before you go through with it. If you later realize it was a bad move, it'll be too late to do anything about it.
A Roth IRA conversion can make sense in certain situations, but it's important to consider the tax implications of the conversion before you go through with it. The wrong decision could leave you with a larger tax bill than you anticipated and no way to pay for it.