Roth IRAs can be a great way to turn your retirement assets into future tax-free income. Since the money inside the Roth has already been taxed, you don’t have to pay taxes on qualified distributions, and you don’t have to take Required Minimum Distributions.
When markets experience a down or volatile year and your portfolio loses value, it creates an opportunity to consider a Roth conversion to minimize the taxes you must pay, potentially helping you to leverage a downturn to your advantage.
However, there’s a lot of fine print that comes along with a conversion and they’re not right for everyone.
What are the factors to consider whether a Roth conversion is right for you this year?
First, you must look at the income tax rate differential between the year of conversion and the year of distribution. Let me explain. A Roth conversion will make sense if you think you’ll be in a higher tax bracket down the road when you take distributions.
A Roth conversion may also make sense when your retirement account has lost value, especially if you can offset some of the taxes you’ll owe on the conversion through tax loss harvesting. However, a Roth conversion may not be appropriate when you expect to be in a lower tax bracket in the year of distribution, because if you’re in a higher tax bracket now, you’ll be paying taxes at a higher rate on the conversion than you would pay on the money coming out later.
A Roth conversion would also be a bad idea when you don’t have cash on hand to pay the conversion taxes you’ll owe, or when you expect to need the money in the Roth account sooner rather than later, because if you withdraw money from your Roth IRA within five years of the conversion, you might owe penalties due to IRS rules.
Bottom line, Roth conversions are a great retirement and tax-planning tool, but the details and your personal situation matter a lot. And, under current tax rules, conversions are permanent. There are no do-overs.
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