Last week, John at Frugal Rules, did a nice post on rolling over your 401(k) into an IRA when you leave your place of employment. It got me thinking about my own experiences of not only rolling over my various 401(k)s into my IRA, but my additional rollover from my traditional IRA to my ROTH IRA a few years back. In the finance world this is called a ROTH conversion and it can be extremely beneficial to your long term retirement nest egg.
As with most IRS rules and strategies for investing in retirement, you have to look at the details to determine if the strategy you take is right for you.Your own personal situation (i.e. current age, risk tolerance, retirement age, etc) play into the equation, so I highly recommend sitting down with a certified financial adviser if you wish to conduct a IRA conversion. In this article I am only trying to point out the benefits and drawbacks of conducting a ROTH conversion, not convince you to run out and convert to a ROTH immediately.
What is a ROTH Conversion?
Very simply, a ROTH conversion is converting your IRA account to a ROTH IRA account. The main decision point in this process is that you will have to pay taxes on the amount of the money and assets you convert to a ROTH. This is because the money in your IRA has not been taxed and a ROTH IRA, by definition, is an after tax account with the benefits of your savings increasing “tax free” over the life of the account.
In other words… with a ROTH IRA you pay taxes up front and have no taxes in the future, even when you withdraw on your savings. With other IRAs you don’t pay any taxes until you withdraw the money, preferably at retirement.
Can Only an IRA be converted to a ROTH IRA?
No, you can also convert to a ROTH IRA from the following list below, so you have various options if your retirement savings are in various accounts.
- 401(k), 403(b), 457 plans
- Traditional IRA, Simple IRA, and SEP IRAs
- Annuity Plans
- Qualified Pension Plans
Should I Convert to a ROTH IRA?
This is a tough one to say “yes or no” to, because it is so dependent on your own personal situation. Usually the answer to this is “yes” if you are young and anticipate your investments increasing in value significantly – and of course, you can pay for the taxes that year. If you are older, it may or may not benefit you, so I recommend talking with a retirement and tax professional before you do anything.
If you are curious and just want to see quickly if it may be worth a conversation. Smart Money has an excellent ROTH conversion calculator that clearly gives you their “yes or no” answer on converting your retirement money to a ROTH IRA.
What if I can’t Pay the Taxes – What Do I Do?
Never fear my friend! If you think you can pay the taxes now, but at the end of the year you realize you cannot. The IRS gives you a nice “out” to the whole conversion process. This “out” is called a Recharacterization.
Essentially a recharacterization of your ROTH IRA allows you to undo your ROTH conversion and switch your savings back into a traditional IRA account. But keep in mind you only have until the late filing deadline to conduct your recharacterization in the next calendar year. So you can’t recharacterize your conversion indefinitely, but you can recharacterize a part of your original conversion if you found you can’t afford all the taxes.
What is the Driving Factor behind Conducting a ROTH Conversion?
In one word – TAXES. Remember that a ROTH IRA is taxed “today” and not taxed on its earnings when you retire. Most people, and myself included, believe that taxes will be “higher” for me when I retire than today. If you disagree, just you look at our world, governments are not eager to lower anyone’s taxes. Frankly, if it were possible I’m pretty sure they would take all my money and leave me utterly dependent..
Taking this into consideration and the fabulous “loophole” a ROTH IRA provides (i.e. no taxes on my savings account earnings). I find a ROTH conversion to be very appealing. This is also why I’ve conducted a ROTH conversion myself in the past, as well as a partial recharacterization when I looked at my tax bill.
Ask the Readers, what do you think? Would you consider a ROTH Conversion in the future? If so, why?
Jason is the founder of frugal habits - a personal finance blog about eliminating debt, saving your hard earned cash, and giving generously. When not enjoying time with his beautiful wife and two daughters - Jason enjoys the great outdoors, reading a great book, traveling the globe, triathlons, and a good cup of coffee.
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Thanks for the mention Jason! Roths are great, and I am definitely one for converting…if that’s best for you. I need to do that for both my & my wife’s rollovers.
John S @ Frugal Rules recently posted..I’ve Joined the Yakezie Challenge!
Anytime John – It was a great article.
Both my wife and I have a Roth IRA. I also have a SEP IRA. I think it’s great because I see no way that tax rates are going to be this low when I want to retire.
Sean, I just can’t see it either. I’ll probably retire in about 20-30 years… I can’t image taxes being less than now. (not that they are low by any means
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I think EVERY person should consider converting their IRA to a Roth, but there are a lot of factors that go into that decision (especially ones that you detailed). We have 2 IRAs right now and should convert them to a Roth…but they’re so small that I just haven’t bothered with it.
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Thanks Jason. I’ve been reading a lot of “experts” say that people should consider doing a conversion this year, due to the pending tax increases next year… Might be a good year for all of us to do a conversion.
I’ve maxed my Roth for the past three years, but income is likely to be too high this year to contribute. I love the idea of a Roth. I do think taxes are only going to go up and I’m afraid they will stop the Roth as is exists today at some point. We’ll see where I’m at when year end rolls around. and if it would be worth it to do a traditional IRA then roll it into a Roth. Good topic!
Kim@Eyesonthedollar recently posted..Being a Boss, The Good, The Bad, and The Ugly
We rolled an old 401k into an IRA when I switched jobs a few years back, and I had never actually considered this option. You make some interesting points tho, and it might be smarter to take the tax hit now, instead of when I am into retirement and will no longer have income flowing in.
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I definitely would recommend a Roth IRA for some retirement funding. The ability to put your money in and take it out tax free cannot be ignored.
However, I do think that politicians have their eye on trading lower income taxes in the future for a new VAT or sales tax. Which would make the Traditional IRA a better choice for tax purposes. I wouldn’t go all in on a Roth.
JP @ My Family Finances recently posted..How Much Does the Average Family Spend on Halloween 2012?
Nice points JP. I too can see this happening. In some ways the limit on ROTH’s is good for me as it forces me to diversify
Jason,
I really enjoyed this article.
Here is my pro-Traditional IRA take.
As I understand it, if you roll a 401k into a Traditional IRA, you can reduce the tax bite when you remove money if you own businesses that allow you to take deductions (in my case, real estate and book publishing).By having the all of the money in your possession, you have more control over how, and when, it gets taxed.
Terry recently posted..Claiming a Tax Exemption When Selling a Home That is Now a Rental
Great thoughts Terry. I’m not familiar with the tax bit when removing money from a traditional IRA, other than the penalties and additional tax burden at the end of the year – but wasn’t taking into account deductions.
I think the Roth IRA is a good idea more to diversify from a tax perspective. I don’t think it does anyone much good to try and calculate if they’ll make more or less money in retirement and let that determine whether they should contribute to a Roth. Who knows what rates will be and how much you’ll be making?!
If you’re going to diversify stocks/bonds you should diversify from a tax now/tax later perspective.
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