 | | | Converting to a Roth IRA | | Watching a movie played on a Blu-ray player at your local electronics store, you may find yourself wondering whether you should ditch the DVD player back home. After all, new innovations usually bump out old products, as MP3s did to CDs. Considering whether to convert the familiar Traditional IRA (introduced in 1974) to a relatively new Roth IRA (1997) poses a similar problem. | |
| What makes a Roth IRA an improvement over a Traditional IRA? Two things: First, while contributions to a Roth IRA aren't tax-deductible, you don't pay taxes on any cash you take out in retirement. That means your earnings aren't just tax-deferred, as in a Traditional IRA, they grow tax-free. Second, unlike Traditional IRAs, Roth IRAs let you contribute money as long as you like, and you're never forced to take it out. | |
| However, a conversion isn't painless. Converting to a Roth IRA means you'll have to pay taxes on the cash you convert. So, you'll either have to use part of your IRA cash to pay the taxes or fork it over from your own pocket. Furthermore, you're not allowed to touch converted money for five years after the conversion without paying a penalty. | |
| Cutting to the chase, here's what you should consider when mulling over a conversion: | |
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If you're married and filing taxes separately for tax purposes, or if you make more than $100,000, you can’t convert, because you're not eligible. |
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If you think you'll wind up in a lower tax bracket in retirement and are planning to spend all of your IRA in retirement, you may not want to convert. |
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If you know you'll need that IRA cash within five years don’t convert—you'll wind up paying the above mentioned penalties. |
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If you'll have to pay taxes out of the IRA money, think careful about converting, since that money will be a lost opportunity—it won't be around to compound. |
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If you can pay taxes out of pocket, you may want to convert, since you'll actually be trading assets that earn taxable income for assets that earn tax-free income. |
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If you want to contribute to your IRA after age 70 1/2, convert. Traditional IRAs don't allow you to do so, forcing you to withdraw cash at that age. |
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If you think your tax rate will rise, it could be a good idea to convert, since you'll have "locked in" your current tax rate when you convert. |
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If you think you might pass your IRA on to your heirs rather than spend it all, a conversion would make sense, since it allows them to withdraw cash tax-free, too. |
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| Of course, you may want to consider having both a Traditional and Roth IRA,, especially if you're not sure where tax rates are headed (you should talk to a financial professional or tax advisor before making a decision). Rest assured, however, that unlike buying a Betamax or HD DVD player, you'll never regret funding an IRA, no matter which kind you stick with. | |
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