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?