Football season is underway, and this is my favorite time to be a football fan. The reason? As a Bears fan and an IU fan, this is when the season still holds promise.
Football season means that fall is just around the corner, and the end of the year not far behind. This is a good time to think about financial moves to make before the end of the year. One move to consider is a Roth conversion. A Roth conversion is a strategic financial move that involves transferring funds from a traditional retirement account — such as a Traditional IRA or 401(k) — into a Roth IRA. The primary aim of this conversion is to potentially benefit from tax-free withdrawals during retirement and to harness other advantages unique to Roth IRAs. Unlike traditional retirement accounts, which typically require you to pay taxes on withdrawals, Roth IRAs allow for tax-free withdrawals if certain conditions are met, making them an attractive option for many investors.
One of the appealing aspects of Roth conversions is that there are no income limits restricting who can convert. This contrasts with Roth IRA contributions, which are subject to income thresholds. However, while eligibility is broad, it is crucial to understand the tax implications of the conversion. The amount you convert will be added to your taxable income for the year, potentially affecting your overall tax situation. Another advantage of the Roth IRA is that it will not be subject to required minimum distributions, unlike traditional retirement accounts. Roth IRAs can be advantageous for estate planning. Heirs can receive tax-free withdrawals, which can be a significant benefit for beneficiaries. In addition to the tax implications, Roth IRAs are subject to something called the Five-Year Rule. To withdraw earnings tax-free, converted funds must remain in the Roth IRA for at least five years. This rule can complicate planning, particularly if you need to access funds earlier.
Deciding how much of your traditional account balance to convert is a key consideration. The amount you choose will impact your taxable income for the year and, subsequently, the amount owed in taxes. A partial conversion might allow you to manage the tax impact more effectively, especially if you're concerned about moving into a higher tax bracket.
The converted amount is subject to ordinary income tax in the year of conversion. It’s essential to calculate how this added income will affect your overall tax situation. Tools like tax calculators or working with a tax advisor can help estimate the additional tax burden and ensure that you are prepared for the tax implications of the conversion.
Timing the conversion can significantly affect its tax efficiency. Converting during a year when your income is lower than usual or when you expect to be in a lower tax bracket can reduce the immediate tax impact. Conversely, converting in a year when your income is high could push you into a higher tax bracket, increasing the amount of tax you owe.
Once you’ve decided on the amount and timing, the next step is to execute the conversion. This involves working with your financial institution to transfer funds from your traditional retirement account to your Roth IRA. Your financial institution can guide you through the process and help ensure that the conversion is completed correctly.
The converted amount will be taxed at your current income tax rate. It is important to have funds available to cover this tax bill, as using funds from the converted amount to pay taxes could negate some of the benefits of the conversion.
After completing the conversion, it’s important to adjust your financial plans and retirement strategy. The conversion might impact your long-term financial goals and retirement planning, so updating your strategy to reflect the new balance and tax implications is crucial. Having a mix of tax-deferred and tax-free accounts can provide flexibility in managing retirement income and taxes, helping to optimize your financial situation.
Roth conversions offer several advantages, including tax-free withdrawals and no required minimum distributions, but they also come with challenges such as immediate tax liability, potential impacts on your tax bracket and the Five-Year rule. Careful planning and consideration of your financial situation are crucial to making the most of a Roth conversion.
Alderfer Bergen & Co. and LPL Financial do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.
Securities and financial planning offered through LPL Financial, a registered investment advisor. Member FINRA/SIPC.