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Converting a Traditional IRA to a Roth IRA

With a traditional IRA, funds contributed are not taxed until funds are withdrawn from the account. Both contributions and earnings are taxed when funds are taken from an IRA. With a Roth IRA, funds contributed are done on an after-tax basis. Under current tax laws, there are no taxes on the contributed funds or earnings when funds are withdrawn.

Converting an IRA to a Roth may be useful depending on your current status.

For example, before 2010, a conversion to a Roth had significant restrictions. However, when those restrictions were lifted, the conversion option became viable to a more substantial number of investors.

When an IRA is converted to a Roth, the amount converted is taxable for the year the conversion was done. It’s important to plan these conversions to maximize tax strategies. From the time the funds are put into a Roth, the investment has tax-free growth potential. A distribution from a Roth that is a “qualified” distribution is excluded from gross income and is not subject to federal income tax. A distribution is qualified after a five-year waiting period. ( Generally, five years after a contribution is FIRST made, or amounts are converted to a Roth IRA)

Additionally, the taxpayer must have reached age 59 ½, but this rule has some exceptions. These include death, disability, and up to $10,000 expenses for a first-time homebuyer. Absent an exception, much like a traditional IRA, and pre 59 ½ withdrawals may be subject to penalty.

When considering converting some or all of an IRA to a Roth, there are many factors to consider.

Factors include but are not limited to: current and projected income, years until the funds will be needed, anticipated taxable income, and availability of cash to pay the added tax liability. Remember that your tax bracket alone is not the only tax-related consideration. One important factor is Premium Tax Credit (PTC), a refundable credit that helps individuals and families cover premiums for their health insurance purchased through the Health Insurance Marketplace. Medicare Income Monthly Adjustment Amount (IRMAA) is another consideration.

Prior to the Tax Cuts and Jobs Act of 2020, an individual could make a conversion and later change it back (recharacterize) within a limited time. That option is no longer available.

If a conversion option is viable, is now a good time? Perhaps !! As many investors have recently seen their IRA values decline, now may be the time to convert. If you think your investments will regain losses and start back on a path to growth, the timing may be suitable. For example, let’s say your IRA that was $200,000 in December is now valued at $160,000. Well, if you own stocks in companies that still have a good long-term outlook, you can move them while they’re down. You will have a tax liability on the $160,000. However, as the stock regains losses and grows, you’ll be able to withdraw those funds in the future on a tax-free basis. (remember the RULE of 72. –at 7.2%, money will double in 10 years). In addition to future tax-free income, you’ll reduce the amount of future Required Minimum Distribution (RMD) requirements. Conversely, If you think your investments will not recover and even go lower, this strategy is not something to pursue. You want to pay taxes on the $160,000 only to later take out less at a later time.

Obviously, converting a traditional IRA to a Roth IRA (or traditional 401k to a Roth 401k) requires careful consideration. Seek professional guidance. We are here to discuss these issues.

June 2022

Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. Examples presented are hypothetical and are not representative of any specific situation. Your results may vary.

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