Roth Conversion Dilemma – 5 Must-Read Tips Before You transform Your Traditional IRA Into Roth

Roth Conversion Dilemma – 5 Must-Read Tips Before You transform Your Traditional IRA Into Roth

Converting traditional IRA into Roth is one of the current topics going on. Many financial firms are too eager for you to switch to Roth and Government has offered one-time motive to transform your traditional IRA into Roth. If you withdraw money from your IRA to move it to a Roth in 2010, you can choose to pay the income tax on that withdrawal over two years, with tax returns you will file for 2011 and 2012.

This might sound attractive at first sight but it carries some risk factors in addition. There are many online free calculators are obtainable to help you gauge the wisdom of conversion. While they can provide you some rough idea of whether it is good for you, they can also mislead you as these calculators are designed with assumptions about some basic variables, investment return, taxation, inflation etc. This may not be true or close for your circumstances and requirements.

With traditional IRA, you pay no income tax on amounts you contribute but your withdrawals will be taxable. Withdrawals from Roth are not taxable if you comply with certain rules. Some financial experts believe that this is the right time now for Roth conversion. In their opinion, today’s tax rates are historically low and national debt will force Government to raise taxes. This is not enough for you to take a decision for Roth conversion. With this decision, you are trying to decide whether you want to pay taxes now or later. Please consider following points before you decide for Roth conversion.

  1. Tax Rate: What is best for you depends on your own tax rate, not rates in general. Do you think your tax rate is likely to rise in retirement? The answer is no for most people. If you stop working, your income will decline and you may fall in lower tax rates. You don’t want to pay hefty taxes now on money that you can withdraw later with lower tax payment.
  2. Over-all Tax Picture: Withdrawals from traditional IRA increase your taxable income and could temporarily put you into a higher tax bracket, or make you ineligible for tax breaks that phase out as income rises. Be careful.
  3. Time Frame: You will have to pay income tax on your withdrawals for Roth conversion. A conversion makes sense only if the Roth IRA grows long enough to make up for the income tax you must pay to create it. This can easily take 7 years or more.
  4. Funds to pay taxes: On your withdrawal from traditional IRA, you will need to pay taxes. Do you have funds outside the IRA to pay taxes you would owe? If you use withdrawals to pay taxes, you defeat your purpose. For example, paying taxes worth $25,000 from a $100,000 IRA withdrawal leaves only $75,000 to earn tax free income on the Roth.
  5. Higher financial priorities: Think about your complete situation and possible future changes in your financial priorities. If you are under 59½, you don’t want to end up paying 10% penalty for withdrawing converted Roth funds within five years of setting up the account.

The best option for you is to consult Certified Financial Planner or Tax Accountant. This might cost you some fees depending upon the firm you use and where you live. But it is worth paying as you will get customized advice keeping in view all your circumstances.

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