Individual retirement accounts (IRAs) come in two flavors: traditional and Roth. With a traditional, contributions are potentially tax deductible and taxes on contributions and earnings are paid when funds are withdrawn in retirement. With a Roth, contributions are made after tax, but withdrawals in retirement are generally tax free.
But even if you have been contributing to a traditional IRA, you are allowed to convert it to a Roth IRA, which may or may not work to your benefit. Before considering a Roth IRA conversion, however, it is important to understand that each type of IRA has its own rules summarized in the table below.
Traditional Versus Roth: Understand the Differences
|Traditional IRA||Roth IRA|
|Maximum Annual Contribution||$6,000 for single taxpayers ($12,000 for couples filing jointly) for 2019. An additional $1,000 “catch up” contribution is permitted for those age 50 or over.||Same as Traditional IRA.|
|Income Thresholds for Contributions||None as long as the account holder has taxable compensation and is younger than 70 1/2.||Single taxpayers with Modified Adjusted Gross Income of $137,000 or more and married couples filing jointly earning $203,000 or more are not eligible to contribute in 2019. Income thresholds are indexed annually.|
|Deductibility of Contribution||Yes, if account holder meets IRS requirements (income restrictions apply if account holder or spouse is covered by a retirement plan at work).||Contributions are not tax deductible.|
|Contributions after age 70 1/2||Not allowed.||Permitted if owner has earnd income.|
|Required Minimum Distributions (RMD’s) after age 70 1/2||RMD’s are required.||Not required during original account holders lifetime. Beneficiaries may be subject to RMD’s.|
|Taxes on Distributions||Distributions are taxed as ordinary income. Withdrawals before age 59 1/2 may also be subject to a 10% penalty.||Qualified Distributions are tax free. Withdrawals from accounts held less than 5 years or before age 59 1/2 may be subject to taxes and a 10% penalty.|
The good news is that converting a traditional IRA to a Roth IRA will not trigger the 10% penalty that early withdrawals from an IRA usually do. But converting will trigger income taxes on investment earnings and contributions that qualified for a tax deduction. If your traditional IRA contributions did not qualify for a tax deduction because your income was not within the parameters established by the IRS, investment earnings will be taxed but the amount of your contributions will not.
When a Conversion May Be Beneficial
Conversion may be advantageous if you are in one of the following situations:
- You do not plan to access your IRA assets for a long time, and your account will have time to potentially grow and compound before you begin withdrawals.
- You are not likely to need the Roth IRA assets for living expenses during retirement. Because you wouldn’t have to take RMDs from your Roth IRA, you could leave these assets intact and potentially bequeath a larger sum to heirs.
When a Conversion May Not Be Beneficial
A Roth IRA conversion may not be in your best interest if the following circumstances apply:
- You anticipate being in a lower tax bracket during retirement. Sticking with a traditional IRA could be the best option because your RMDs would be taxed at a correspondingly lower rate.
- You plan to retire in the near future. Should you convert, your Roth IRA may not achieve adequate short-term growth prior to withdrawals to compensate for the tax payment.
- You plan to access the IRA for living expenses, and a bequest to heirs is not an issue.
Converting assets within a traditional IRA to a Roth IRA presents potential benefits, but only if the time horizon, tax issues and estate planning parameters work to your advantage. Review all angles to make sure you make the right choice.
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