When completing a financial plan, many questions may arise. One of the biggest questions I get is whether to contribute to a Roth IRA or a traditional IRA. The next biggest question I get is whether a Roth conversion is an appropriate action. IRAs and Roth IRAs each have different tax benefits; however, determining the most appropriate investment vehicle can sometimes be daunting.
The Basics: Traditional IRA vs. Roth IRA
The traditional IRA usually provides the investor with a tax benefit up front. This means that the qualifying investor appreciates the tax benefit now and pays the tax at a later date. Contributions are made with pre-tax money and are usually fully or partially tax-deductible (based on income and/or if you or your spouse is covered by a work-sponsored retirement plan).
The following IRS links can help determine if your IRA contribution is a tax deduction or not:
On the other hand, Roth IRA contributions provide no tax benefit up front; the tax benefit occurs when you are ready to withdraw the funds in retirement. Deposits into Roth IRAs are completed with already taxed money. The principal and growth in the account grow tax-free and no taxes are due at retirement (if you follow some basic IRS guidelines).
Another major difference between traditional IRAs and Roth IRAS is required minimum distributions (RMDs). While there are no RMDs associated with Roth IRAs, traditional IRA RMDs currently occur at age 72.
Roth IRA Conversion
A Roth conversion is the transfer of funds from the traditional IRA into the Roth IRA. This process results in a taxable event for the individual completing the conversion. The conversion amount is taxed as ordinary income tax to the individual.
A conversion to a Roth IRA results in taxation of any untaxed amounts in the traditional IRA. (1) Deciding if a Roth conversion is right for your financial situation usually comes down to a few financial opinions regarding future tax rates.
Consider these questions:
- What tax bracket are you currently in?
- What tax bracket will you be in at retirement?
- Would you rather pay taxes now or in retirement?
- Are taxes going up or down?
The answers to these questions can help you better understand if a Roth conversion is good for you.
Conversion or Not?
A Roth conversion may be right for you if:
- You believe you will be in a higher tax bracket once you are ready to take funds out for retirement.
- You believe taxes are going to be higher in retirement.
A Roth conversion may not be right for you if:
- You believe taxes are going to be lower in retirement or are in a higher tax bracket now.
Remember, Roth conversions require that you pay taxes on all money that comes out of the traditional IRA and into the Roth IRA. The goal for this action is to lower your tax bill over the course of your financial future.
What if you make too much money to contribute directly to a Roth IRA? A backdoor Roth is a process for getting funds into the Roth IRA even if your income is too high. According to Investopedia.com, a backdoor Roth is “an informal name for a complicated method generally used by high-income taxpayers to create a permanently tax-free Roth IRA, even if their incomes exceed the limits that the tax law prescribes for regular Roth ownership.” (2) An investor makes a non-deductible traditional IRA contribution and then completes a Roth IRA conversion.
We recommend you discuss this option with your financial advisor to make sure it’s the most valuable move for your retirement plan.
If you still have questions, please feel free to reach out to your advisor at Shelton Financial Group or give us a call at 260-436-7006 to discuss anything in this article in more detail.
Investment Advisor Representatives of, and securities and advisory services are offered through USA Financial Securities Corp., Member FINRA/SIPC. A Registered Investment Advisor located at 6020 E. Fulton St., Ada, MI 49301. Shelton Financial Group Inc. is not affiliated with USA Financial Securities.
About Shelton Financial Group
Shelton Financial Group is an independent, multi-generational firm in Northeast Indiana that takes a team approach to addressing their clients' most pressing financial concerns. SFG was founded in 1996 with the mission of helping people enjoy their wealth. Using their proprietary “One Life Formula,” the team at SFG focuses on what matters most to their clients and what they can control, integrating their wealth management needs with other aspects of their financial picture. To learn more about Shelton Financial Group and how they can help you achieve financial independence, visit them online.
The information expressed herein is obtained from sources that are believed to be credible, however, their accuracy cannot be guaranteed. All data is created from publicly available information and has not been independently verified by USA Financial.