While future distributions following the conversion will not be subject to income tax, converting an IRA to a Roth IRA is treated as a distribution where the taxpayer recognizes taxable income. Income from conversions is recorded in the year of conversion. IRA contribution calculator Answer a few questions to find out whether a Roth or a traditional IRA might be right for you. The primary reason people convert traditional IRAs or other retirement accounts to Roth IRAs is so they can earn tax-free income when they retire.
In addition, Roth IRA conversions can be disadvantageous for those who intend to give away at least some of their assets to charitable organizations. If you’re retiring and have topped up company stocks in your traditional 401 (k) or other qualified corporate savings plan, it may not make sense to convert those assets into a Roth IRA. In addition, the income taxes paid during a Roth IRA conversion can also help reduce the size of a taxable estate. In general, it makes sense to use taxable assets rather than proceeds from a converted account to pay the tax costs of a Roth IRA conversion (and you may be able to reduce the taxes owed through deductions and credits, thus avoiding selling assets to cover the bill).
It may be an advantage to convert before you reach the age of 73, otherwise you’ll have to take RMD before each conversion. Traditional IRAs can usually be left to charity without having to pay income tax (although inheritance tax may apply). Under the SECURE Act, heirs must withdraw the full account balance of an inherited IRA by the 10th anniversary of the original owner’s death. A backdoor Roth IRA is a colloquial term for a technique that allows wealthier taxpayers to bypass income limits to open a Roth IRA.
A Roth IRA conversion involves transferring retirement savings from a traditional, simplified employee pension (SEP) or SIMPLE IRA, or from a defined contribution plan such as a 401 (k) to a Roth IRA. If you have kids who are just going to college or are about to go to college and are applying for financial aid, switching to Roth IRA may have an impact. If you request this, some universities may adjust their calculation to include Roth IRA conversion income in their private financial aid formulas, but state aid formulas cannot. So if you live in a state or plan to live in a state that excludes retirement income from state income tax, switching from a traditional IRA to a Roth IRA may be less appealing.
If your future state of residence has a higher state income tax rate than your current one, it may make sense to convert at least some of your eligible assets into a Roth IRA before you move. That’s because, all things being equal, the return on a Roth IRA is generally higher because there are no taxes due on gains in a Roth IRA and taxes reduce the returns you earn.