A Roth IRA is a type of individual retirement savings account that, like a traditional IRA, allows savers' investments to grow untaxed. The big difference is that when funds are withdrawn from a Roth IRA, there are no tax consequences, whereas traditional IRA withdrawals are taxed as ordinary income, just like withdrawals from pensions or taxable accounts.
That's one of the reasons many savers choose to move some or all of their savings from a traditional IRA to a Roth IRA. Should you consider doing the same in tax year 2015?
Reasons to convert to a Roth
If you convert any portion of your traditional IRA to a Roth IRA, the money you move is taxable in the year that you move it. However, once those dollars are transferred into your Roth IRA, they continue to grow with no tax implications, and they can also be withdrawn tax-free when you decide you need that income in retirement. It's also good to know that Roth conversion amounts are not subject to the 10% penalty that is assessed on IRA funds withdrawn before you reach age 59-1/2, so you can do the Roth conversion at any age.
So when should you consider a Roth IRA conversion as a year-end tax strategy? Let's say you had a big tax deduction this year and your marginal tax rate will be lower than normal, or you have decided to work part-time as you head into retirement, and your income will be far lower than it has been in the past. Even in an ordinary tax year, moving a small portion of your qualified funds into a Roth as you near retirement might make sense if you think you may have substantial tax liabilities in the years ahead.
Many Americans assume their incomes, and thus their taxes, will be lower in retirement, but that is often not the case. Many folks get clobbered with income taxes in retirement when it comes time for them to take their required minimum distributions (RMDs) at 70-1/2 due to the fact that they have large tax-deferred retirement accounts. There are also other reasons to lower your taxable income in retirement, like the fact that your Medicare Part B premiums are based upon your income.
How a Roth conversion works
So, if you decide that a Roth conversion might be an option for you, the mechanics are simple. It's usually best to do this via a trustee-to-trustee transfer, which means the money is never in your hands. Rather than withdrawing money from your IRA, contact your broker and take the steps necessary to open a Roth IRA. You should then decide which assets you would like to transfer -- you don't have to liquidate anything -- and then instruct your broker to move those assets. You can move portions of accounts or entire accounts. Your broker may have a standard form used to make the transfer, or they may simply ask you for a letter of authorization. The IRS will send you a Form 8606 when you complete your income taxes for that year, and you will pay the taxes on those funds when you file your return.
I must warn you that while Roth conversions are a smart choice in many situations, there are times when you should leave your funds be. My friend Gretchen was approached by someone who claimed to be a financial advisor. This person encouraged Gretchen to convert funds from her traditional IRA to a Roth IRA. This person never even asked Gretchen about the types of income (like Social Security) she anticipated having in retirement. It turns out that she had not saved very much, and income taxes would be the least of her concerns in retirement. In fact, she would probably have no income tax liability from her retirement income as things stand today. Worse yet, this supposed advisor made no inquiry about her current income situation. Gretchen's business was not doing well, and she was barely meeting her monthly nut. Subjecting her to additional taxes of $2,000-$3,000 today would be an awful burden on her, and it may well have put her out of business.
Why would an advisor do this? Sadly, not all advisors are looking out for our best interests; some may only be looking out for their own wallets, encouraging clients to convert traditional IRAs to Roth IRAs in order to generate commissions. We ran a broker check on this advisor, and we discovered that they had 10 customer complaints and/or FINRA fines on their record. Granted, in our litigious society, frivolous complaints aren't unheard of, but 10 dings is a glaring red flag.
So if your broker/advisor suggests that you convert your current traditional IRA into a Roth IRA, then ask why. Ask them to show you the numbers. Only then can you decide whether a Roth conversion is the right choice for you.