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Converting a Traditional IRA to a Roth IRA, When Does It Make Sense?

IRAs are Individual Retirement Arrangements. There are several types of IRAs with differing contribution limits and earnings thresholds. Funds for an IRA must come from employment earnings. More information about all IRAs and their regulations can be found on the IRS website

Most individuals have either a Traditional IRA or a Roth IRA. In most cases, a Traditional IRA is tax deferred. Meaning, you will not have to pay income taxes on the amount you contribute, but you will have to pay income taxes when you take disbursements during retirement. A Roth IRA is not tax deferred, but distribution payments are not taxed at the time of disbursement. 

Because of differing tax implications, there may be instances when it makes sense to convert a Traditional IRA to a Roth IRA.

Who Can Convert a Traditional IRA to a Roth IRA?

Anyone can convert a Traditional IRA to a Roth IRA. This includes individuals that earned too much to qualify for a Roth IRA. There is no income threshold for conversion. 

When Does It Make Sense, When Does It Not Make Sense?

Converting a Traditional IRA to a Roth IRA makes sense when you expect your income to go up in future years.  This is due to the aforementioned fact that Roth IRAs have non-taxable distributions.  If the taxpayer expects to have a higher tax rate when they take distributions vs. when they are contributing to the Roth IRA then converting to a Roth is beneficial to the taxpayer.

Conversely, if you expect to have a lower tax rate in future, it makes more sense to take the tax deduction during your higher earning years. This reduces your overall tax burden.

When Should You Make the Conversion?

As far as timing the actual conversion goes, if a business owner or employee has a down year in income for whatever reason and finds themselves in a lower bracket than usual, or sometimes even with no taxable income, it could be a great time to convert as the conversion itself is a taxable event.

Conversions must be made by December 31st of any given tax year.

How Do I Estimate My Tax on the Conversion?

You need to know what tax bracket you are in.  For example, if you make $200K a year and are married that would put you in the 24% tax bracket.  Your Roth IRA conversion will be taxed at 24%. 

However, you need to be careful, as the conversion could move you into a new tax bracket. Estimating your tax liability before making the conversion is crucial. You will pay income tax on the total amount that you convert. Remember, when you contributed to your Traditional IRA, you did not pay taxes on that income, so when you convert to a Roth IRA, you must pay the tax that was previously deferred but now will be taxed at your current tax rate. 

Because of this, it is worthwhile to contact a tax professional before making a final decision. If you have questions, please contact Fates, Bodily & Parker.

Can You Revert Back to a Traditional IRA?

Yes, but this is only advisable under certain circumstances. You should always consult with a tax professional before reverting back to a Traditional IRA.

How Do I Get Started?

The first step is to consult with your tax professional to see if this is right for you. If you decide to move forward, you will need to contact your financial institution that is administering your Traditional IRA to find out their conversion requirements.

What Do I Need to Properly File the Conversion on My Taxes?

You will receive a 1099-R from your financial institution when the conversion is complete. You will need to provide this form to your CPA.  This form will need to be reported on your tax return. 

Because taxpayers are unaccustomed to receiving 1099-R forms, they may fail to be on the lookout for it. This can cause the lump sum of taxable income to be missed at tax time, leading to serious issues with the IRS. 

The best way to avoid this problem is to talk to your CPA before the conversion and after the conversion so they are aware of the change. Make sure you are on the lookout for the 1099-R form and provide it to your CPA once you have it. 

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