Ignorance of the law is no excuse, and with a few exceptions, the IRS is not very forgiving for mistakes. By knowing the rules, you can avoid the many potential IRA tax traps you could run into on your way to retirement. Switching a traditional IRA or fund from a SEP IRA or SIMPLE plan to a Roth IRA can be a good choice if you expect to be in a higher tax bracket in your retirement years. If you’re getting Obamacare or filling out a FAFSA application, it’s important to consider this when deciding how much, if any, you want to convert.
When you convert a traditional IRA to a Roth IRA, you owe tax on any money in the traditional IRA that would have been taxed when paid out. The idea is to convert the amount you want to withdraw in your first year of retirement at least five years earlier so you can withdraw those funds with no penalty until you’re ready to use them. During a Roth IRA conversion, the retirement savings are transferred to a new or existing Roth IRA account. With Roth IRAs, you can deposit money after tax to receive tax-free distributions later on.
If the value of your retirement account has dropped, this could be a good time to switch to a Roth IRA, as the tax impact is lower than if your account is worth more. A Roth IRA conversion is a strategy that people use to convert their tax-deferred retirement savings, such as traditional IRA and 401 (k) funds, into Roth savings so they can enjoy tax-free withdrawals when they retire. Similarly, it’s not prohibited to own real estate directly in an IRA, but you could get involved in a prohibited transaction if you’re not extremely careful. However, people in this situation can still convert traditional IRAs into Roth IRAs, the strategy known as the backdoor Roth IRA.
It is generally advisable to carry out the conversion over several years and, if possible, convert more into years when your income is lower. It’s not as common, but if you’ve made non-deductible contributions to a tax-deferred retirement account and later decide to convert some of that money to a Roth IRA, you won’t have to pay taxes on your basis. However, under the SECURE Act’s new 10-year distribution rules, some beneficiaries of a tax-deferred IRA may be better off making distributions in each of the 10 years to avoid a heavy tax bill in the 10th year, in which all inherited assets must be distributed. The easiest way to do a Roth IRA conversion is to ask your tax-deferred retirement account provider to transfer funds to your Roth account.
Plus, Roth IRAs don’t allow you to trade on margin, meaning you can’t use your retirement account for leveraged transactions.
