Should You Convert Your IRA or 401k to Roth?

Are you thinking about converting your IRA or 401k to a Roth? Doing so may or may not be a good idea. If you have a traditional IRA or 401k, your money is currently growing tax deferred and you'll pay tax on the money as it is drawn out at retirement. So why might you want to convert? Read on to learn the benefits, and who is a good candidate for this kind of switch.

Reasons to Convert Your Traditional IRA/401 to a Roth

A Roth is the opposite of a traditional IRA or 401k. Roth IRAs and 401ks grow and the money invested in them is distributed tax free when you decide to retire. So if you had a Roth, you'd pay taxes now and pay no taxes on distributions when you decide to retire.

The benefit of paying now is it's less money in the long run. If you can afford to pay taxes today, they'll be cheaper than their equivalent in 20 or even 5 years. $20 today can inflate dramatically in the time until you retire.

There are several differences between traditional and Roth accounts. To put it simply, a Roth is best for you if you plan on being in a higher tax bracket then the one you're in now when you retire. If you plan on being in a lower tax bracket, a traditional account is better for you.

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Roth IRA Conversion Doesn't Have to Be Forever

Yes that's right! If you have second thoughts, you can convert at any time. The good news is you can convert your traditional IRA to a Roth IRA, or your traditional 401k to a Roth 401k. The price to make that conversion is including the amount you convert to Roth as taxable income for the year in which you make the conversion.
For example, if you convert $100,000 from your traditional IRA to a Roth IRA in 2017, you will list $100,00 as income on your 2017 tax return. You will then pay any federal and state taxes on that income depending on your 2017 tax bracket.

You probably don’t like the idea of paying additional taxes to convert. Honestly, who would? Nobody likes paying their friends at the IRS more taxes now. However, you can easily end up saving more money as your account grows and the entire growth comes out tax free.

Three Situations Where Converting Your IRA or 401k Funds to Roth Is Your Most Profitable Option:

  1. Expecting Higher Than Average Returns From An Investment Opportunity.

If you're about to make an investment you expect will produce huge returns, then it'll be in your best interest to convert to a Roth.
Wouldn't you rather pay tax on the smaller investment amounts now? Those larger returns will go back into your Roth IRA or 401k, where they will grow to an unlimited amount and come out tax free.
I realize this is hard to predict. After all, if it was easy we'd all be rich. However, a situation like this is bound to happen when you're investing in real estate, startups, pre-IPOs, and other investments.

  1. Low Income Year.

The biggest pain of a conversion is that you have to pay tax on the money you convert. The best time to convert is when you're in a lower tax bracket because you'll end up paying less in taxes.
For example, if you are married and have $50K of taxable income for the year and you decide to convert $100K to Roth, you will pay federal tax on that converted amount at a rate of 15% which would result in $15,000 in federal taxes.
And don't forget about state income tax (if you live in a state that actually has one) because they tax conversions the same way the fed does!

If you choose to convert when you're in a high tax bracket at around $250,000 of income, then you’d pay federal tax on a $50K conversion at a rate of 33%. This would result in federal taxes of $16,500. In other words, that's one third of your money down the drain. Ouch!

Unfortunately, many of us have careers where we can't just expect to be in a lower tax bracket. This option is probably more likely for those who are self employed as small business owners, consultants and freelancers.

  1. You'd Rather Have The Money Sooner Instead Of Later

Roth accounts are kind of like the gift that never stops giving.  With a Roth you can take out the funds you've contributed or converted (NOT the earnings) after five years without paying tax or the early withdrawal penalty. Even if you aren’t 59 1/2.

For Roth conversions, the amount you convert can be distributed from the Roth account five years after the tax year in which you converted. The five-year clock starts to tick on January 1st of the tax year in which you convert, regardless of when you convert within the year.

Let's say you converted your traditional IRA to a Roth IRA in May 2017. You'd be able to take a distribution of the amounts converted without paying tax or penalty on January 2nd, 2022.

Whereas if you try to access funds in your traditional IRA or 401k before you are 59 1/2, you will pay tax AND a 10% early withdrawal penalty even if the amounts you distribute are only the contributions you put in, not the investment gains.

Roth accounts offer you flexibility, plain and simple. So if you're looking to always have access to your retirement money, a Roth is what you need!

Final Thoughts on Who Should Convert to a Roth

Whether or not you should convert to a Roth largely depends on your future. Will you be richer or poorer when you retire? Also, many employers are willing to match your contributions to a traditional 401k to a certain degree, whereas for a Roth they aren't.

For most people, a Roth conversion simply isn't worth the money. But for some circumstances, it's a no-brainer. If you need help determining if a Roth conversion is in your best interest call Royal Legal Solutions now at (512) 757–3994 to schedule your retirement consultation.

Last Updated: 
November 26, 2017

Scott Royal Smith is an asset protection attorney and long-time real estate investor. He's on a mission to help fellow investors free their time, protect their assets, and create lasting wealth.

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