There are numerous reasons to move to a Roth IRA: avoiding the possibility of greater taxes in retirement, having no RMDs, and cheaper markets.
Consider a Roth IRA as an excellent retirement vehicle. Contributions are not tax-deductible, but withdrawals are tax-free, and this affords the prospect of substantial tax-free investment returns over the account’s lifespan.
This is in contrast to a standard IRA, where contributions are tax-deductible, but withdrawals are taxed afterward. While there are income restrictions on Roth contributions, conversions to Roth IRAs do not have income restrictions. When conditions are right, your IRA can be converted into a Roth IRA, taxes paid on the transfer, and then make tax-free distributions from the Roth IRA. Taxes should be paid with cash rather than IRA money to maximize benefits.
Here are six justifications for a Roth IRA conversion.
#1 In retirement, you might be in a higher tax bracket.
If you plan to be in a higher tax band in retirement, it may make sense to convert your traditional IRA to a Roth IRA. By paying the tax when your tax band is lower, you may maximize the tax efficiency of your retirement assets.
In many situations, it is challenging to affect your tax bracket, and during your working years, your wages determine which tax bracket you fall into. In retirement, though, Social Security and required minimum distributions (RMDs) are recurrent payments that affect your tax bracket, and RMDs are required minimum distributions from IRAs beginning at age 73.
However, with careful preparation, there is a window of time after retirement and before RMDs begin, during which you may be able to decrease your tax rate and convert your traditional IRA to a Roth IRA. Social Security benefits may potentially be deferred until age 70. If this window is prepared for by saving for retirement costs, the tax bracket will be low, and it will be an ideal opportunity to convert to a Roth IRA.
#2 Requirements for minimum distributions do not apply to Roth IRAs.
As previously stated, conventional IRAs require RMDs beginning at age 73. Even if the money is not required, it must be removed and taxed, which might cause you to fall into a higher tax rate. In addition, failing to withdraw the RMD might result in a 25% penalty, which is reduced to 10% within two years of withdrawal.
Even if the IRA is not needed for retirement costs, many may believe that delaying withdrawals is the wisest course of action because it delays any tax liability. However, this may also result in increased RMDs and, hence, increased tax liability. The absence of RMDs from Roth IRAs protects against these possible hazards.
#3 Roth IRA-Based Tax Diversification
Roth IRAs are advantageous for tax diversification. Thus, you may examine your tax situation annually and select from which account you should withdraw funds when they are required. For instance, Medicare premiums incur an additional fee when income reaches specific thresholds. If your taxable income is approaching one of these thresholds, but you still need money to cover costs, withdrawing funds from a Roth IRA may be the best option. You will get your cash, cover your bills, and avoid paying increased Medicare payments.
Taxes on Social Security income are another prevalent circumstance affected by income levels. As your taxable income exceeds certain thresholds, a greater portion of your Social Security benefits become taxable. Withdrawals from an IRA might cause your income to rise to the point where you are subject to the 3.8% Medicare surtax on investment income.
There is no surtax on IRA withdrawals, but you may have to pay it on dividends, interest, and capital gains if your income reaches a certain level. Tax diversification is the answer to these issues. By contributing to a Roth IRA, you can avoid exceeding the levels at which these additional taxes begin.
#4 Regarding estate planning, Roth IRA income is exempt from taxation for beneficiaries.
Congress’s 2019 passage of the SECURE Act altered the inheritance of IRAs by non-spouse recipients. Previously, a non-spouse beneficiary may inherit an IRA and receive withdrawals throughout their lifetime, and this helped to stretch the tax load over several years.
The SECURE Act mandates that recipients dispose of their entire IRA within ten years. There is now a smaller window in which those monies must be removed and taxed, regardless of how they are withdrawn.
With a shorter window, these greater withdrawals raise the likelihood that beneficiaries would be pushed into a higher tax rate. Although a Roth IRA must be withdrawn within ten years, the income is not taxed to your beneficiaries.
#5 Your filing status for taxes may change.
As indicated before, years spent in a lower tax band are ideal for investigating Roth IRA conversions. This is frequently a result of income levels, but your tax filing status may also be a significant variable that may alter over time. Compared to other file statuses, married couples filing jointly receive a higher income at a lower tax rate.
Death and divorce may modify this and put you in higher tax brackets due to less advantageous filing status, but widows get a two-year grace period.
While no one anticipates or desires this to occur, it may be a factor in some instances, particularly for spouses with a large age gap who do not anticipate remarriage.
#6 The market has fallen.
When the stock market is declining, converting to a Roth IRA may be advantageous. You will be able to convert additional shares at a lower price and have the potential future gain be tax-free, as it will now be in the Roth IRA. In addition, you may also specify which shares you wish to convert if you are undertaking a partial conversion, selecting the equities that you think have the best growth potential.
There are several reasons to pursue a Roth conversion. Importantly, each conversion has its five-year period during which you cannot withdraw assets without incurring a 10% penalty. But if the money is not needed, the benefits of conversion might be quite great.