With today’s lower tax rates, does converting traditional IRAs to Roth IRAs make sense for you?

Roth IRAs

With lower tax rates in play, does rolling over traditional IRAs to Roth IRAs make sense? Let’s first outline the similarities and differences of each IRA. The most important consideration you face is deciding how and when you pay taxes on your investment.

Traditional and Roth IRAs definitions

Traditional IRAs are an avenue for you to save for retirement with many tax benefits. The contributions you make can be fully or partially deductible depending on specific qualifications. Later, the deductible amount of your distributions or withdrawals are taxable.

Roth IRAs are very similar to traditional IRAs. The distinctive difference is that you do not pay taxes on retirement withdrawals or distributions because you invested post-tax compensation when you contributed to your funds. Additionally, unlike most traditional IRAs which require you to start taking funds from your accounts once you reach the age of 70 ½, you will not face these required minimum distributions (RMDs) in retirement.

How they compare

Who can make contributions

Traditional IRAs allow you (or your spouse) to make contributions to your account at any time until you reach the age of 70 ½. In contrast, Roth IRAs allow you to make contributions at any time without an age limit. Importantly, the funds you invest in either retirement plan must be from taxable compensation.

Deductible contributions

While Roth IRA contributions are not tax deductible, you may deduct contributions to a traditional IRA if you qualify, because you will pay taxes on those funds later. Moreover, qualifying deductions rely on whether you are (1) covered by a workplace retirement plan and (2) if your income does not exceed certain levels.

How much you can invest

Both types of IRAs have limitations on the amount you can invest per year. For 2018, anyone of any age may contribute $5,500 to their retirement plan. If you are 50 years of age or older, you may contribute an additional $1,000. If your total taxable compensation for the year is less than the above cap, you may invest all your taxable compensation into the retirement plan.

Contribution deadline and withdrawals

You can make contributions for either plan at any time during the fiscal year. In order to claim your contribution to a traditional IRA as part of your tax filing however, you must make your investment before your tax return filing deadline (not including extensions) of the following year. Thus, for 2018, you must make your contribution by April 15, 2019. Withdrawals from either plan can be done at any time but you could face a 10% tax on early distributions if you are under the age of 59 ½ (unless you qualify for an exemption).

Required minimum distributions (RMDs)

To simplify the terminology, required minimum distributions (RMDs) are the minimum required withdrawals you must take out of your traditional IRAs each year. You can withdraw as much as you need, but once you are 70 ½, the federal government mandates the withdrawal of a specified minimum amount. In addition, the total withdrawal value will be part of your yearly taxable income. To calculate your RMDs, use one of the IRS’s two worksheets. Deciding which one to use is based on whether your spouse is more than ten years younger than you and your sole beneficiary. In contrast, Roth IRAs do not require RMDs.

Does the rollover make sense

Deciding on whether the rollover makes sense is entirely up to you. The consideration is whether you want to pay taxes now or wait. This is the main difference between the two plans. Consider the following two perspectives in addition to all of the above.

If retirement is still many years away, consider creating a Roth IRA and begin making contributions now. With the lower tax rates available today, you could be paying less taxes now than you might see down the road. Remember, this is speculation that tax rates will increase in the future.

If you are close to retirement and you want to roll over all your savings from a traditional IRA, be careful. You could face a significant tax liability on the rollover for the taxes you have not yet paid. Also, this could place you in a higher tax bracket for the year depending on the amount you choose to move. However, you do have the opportunity to decide whether you pay the taxes on this rollover money all at once or over the next couple of years before your retirement. Also keep in mind that you have 60 days to complete the transfer from an existing retirement account into a new one or you could face penalties.

If you have additional questions on whether you should or shouldn’t roll over your traditional IRA to a Roth IRA, contact your CPA.

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