Converting to a Roth IRA

Many people who have traditional IRAs may, at some point, wish to make the switch to a Roth IRA. If you’re considering this decision, rest assured that making the switch really isn’t all that difficult and can sometimes be beneficial depending on your financial situation.  

Why Make the Switch?

First of all, you should know that traditional IRAs work great for many people. However, there are some instances in which you may wish to switch to a Roth IRA.   

Basically, if you are hoping to make more post-tax money, a Roth IRA is a solid choice. The reason for this is because when you switch, you lose the tax deferral that you get with a traditional IRA. While this situation is not ideal for all taxpayers, it can work in your favor, so check with your financial adviser to determine if this is a smart move for you.

Converting Funds

If you do ultimately decide that a Roth IRA is a better choice for you, let your bank know that you wish to make the switch. You don’t even have to change banks or change up your investments. You can simply designate that they go into a different type of account.

Actual conversion of the funds can be a bit trickier, but with the help of your bank and your financial advisor, you can make the switch work in your favor. If, for some reason, you can’t get the tax conversion to benefit you and it’s going to cost more than benefit you, then you may wish to rethink your decision, at least for the time being.

Converting your IRA is a bit complex, but, with good help, you can make the right decisions for you, your accounts, your financial state, and your future.

Where to Stash Your Retirement Cash

Most people realize that they need to save money for retirement. Unfortunately, though, a lot of people are unsure of where they should be saving that money. There are actually quite a few different options to choose from, such as money market accounts and standard savings accounts, but most financial experts agree that the two best options are 401(k)s and IRAs. These savings options can cut taxes and increase the amount of money that actually makes it to savings.  

As mentioned, both options are beneficial. Thus, which one you should choose really depends on your personal needs and savings goals. While you’d likely fare just fine with either choice, it’s always smart to talk to a financial advisor to determine the best savings option for you specifically.

401(k)s

A 401(k) plan is the way to go if you don’t mind a limit on how much you can deposit or if the limits are within your planned deposits. As of this year, you can put up to $18,000 in your 401(k) without paying a cent in taxes, and if you’re 50 or older, you can even add on an extra $6000 without getting taxed! Plus, in most cases, your employer will be willing to match  your donation amount, which can really get the money flowing!

Another great benefit of a 401(k) is that you’ll likely be provided with professional advice and management of your account. That’s because employers are required by law to be honest and open about fees and investment choices, and most don’t want to take any chances of getting in trouble by mismanaging or otherwise being misleading about your 401(k).

401(k) funds are also protected in the event of litigation or bankruptcy , which offers an extra layer of protection to your retirement fund.

So, if you want these benefits, a 401(k) may be for you! However, if you don’t like lots of limits and want more investment and growth options, you may do better to choose an IRA.

IRAs

Like 401(k)s, IRAs give you an opportunity to stash away money for retirement without paying taxes on it. However, there are some restrictions in place, including income limits. Single adults who make above $61,000 each year, for example, cannot deduct contributions to their IRAs tax free. However, with some types of IRAs, such as Roth IRAs, you do have the option of withdrawing money tax-free, so it’s kind of a give and take.

Even with this restriction, many people still find IRAs to feel less restrictive than 401(k) plans. However, with an IRA, you won’t enjoy the same kind of protection you would with a 401(k) and you’ll be the one responsible for figuring out the best way to invest with your IRA or hiring and paying a professional to do it for you since workplaces typically don’t offer help with IRA management.

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Your Money Questions Answered

Commonsense solutions to your financial concerns
By Lea Ann Knight, CFP

Few Americans are without money woes—whether it’s planning for retirement, deciding what to do with a windfall or debating a switch to an online bank. Here, certified financial planner Lea Ann Knight, author of the weekly blog Financially Fit After 40 and owner of Garrison/Knight Financial Planning in Bedford, Mass., takes a stab at some frequently asked financial questions. 

Make the Most of Extra Cash

Q. I received a raise a few months ago and have been using the extra cash to pay down my new mortgage. Should I be doing something else with the money instead? 

A. Because mortgage rates have been at historic lows recently, consider putting those extra dollars to work somewhere else. The average return in the stock market has been around 8%, so one good alternative is to invest what’s left over from your paycheck each month in a basic stock-index mutual fund at a low-cost brokerage house. Or you could add the money to your retirement savings. But if you feel like you’re on track financially and you have surplus cash, then paying down debt with a low interest rate can be a smart move.

Maximize Your Retirement Savings

Q. My company is now offering a Roth 401(k) in addition to the traditional 401(k) plan. What would be the financial benefits of switching my 401(k) contributions to the Roth version?

A. The advantage of contributing to a Roth 401(k) is that, although you can’t take an annual tax deduction now, you will be able to withdraw your money tax-free in retirement. If you think you might be in a higher tax bracket when you’re older, a Roth 401(k) is a good idea. But if you like having that pretax deduction each year, you might prefer to keep your money where it is. Alternatively, as long as you are single and earn less than $110,000 yearly (or your combined annual income if married is less than $173,000), you may continue your traditional 401(k) plan at work and contribute up to $5,000 per year to a Roth IRA as well. Having both types of accounts in retirement will give you more flexibility with withdrawals and help you minimize taxes in your golden years.

Decide if an Elderly Parent Still Needs Life Insurance

Q. My dad has retired but is still paying premiums for a large life insurance policy. His house is paid for, and all his children are independent. Does he still need this insurance?

Insurance (Photo credit: Christopher S. Penn)

A. Assuming there will be no financial obligations for his estate to meet in the event of his death, your father might no longer need to keep paying for the insurance policy. If that’s the case and his is a term life insurance policy—which provides coverage for a set amount of time—with no cash value, he can simply stop paying the premiums to end his coverage. If, on the other hand, it is permanent life insurance, the policy might have a cash surrender value, meaning he could cash it in (and pay income tax on the proceeds) or use the cash value to start paying for his premiums. The latter option is appealing if he wants to keep enough value in the policy to help pay for his burial expenses or wishes to leave the death benefit to his heirs. Before he acts, however, he should review his choices with a financial planner to determine which option makes the most sense for him.

Consider Additional Disability Coverage

Q. My company benefits plan includes some disability coverage, but not at my full salary. Should I supplement with private disability insurance?

A. Many employers offer long-term disability plans that cover 60% to 70% of your salary if you become unable to work. Private policies can be pricey, so decide how much of your paycheck you need to meet your monthly expenses in such an event. If it’s within the employer-covered amount, you likely don’t need a private disability plan, but if you’re the sole breadwinner with young kids and a big mortgage, it might be a good bet. Also consider how close you are to age 65, when many such policies terminate anyway.

Weigh the Pros and Cons of Online Banking

Q. I’ve heard that online banks offer great interest rates, but I’m not sure if they’re safe. Are there any other drawbacks?

A. Before you switch, confirm that your account will be FDIC-insured, meaning your money will have the same protection as it would at a brick-and-mortar institution should the bank fail. And recognize that although many online banks can offer a higher interest rate because they don’t have the same overhead as traditional banks, it will take longer to get your hands on your money in an emergency and—if you must make deposits by mail—for checks to post to your account. Also think about how often you need services such as certified checks—which might not be as easy to obtain online. Consider two accounts: your local bank for day-to-day needs and an online one for savings. That way you’ll still have easy access to some of your money but will earn higher interest on what you don’t need today.

Adapted from the Aug. 24, 2012 issue of All You. © 2012 Time Inc. All rights reserved.

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To Convert or Not to Convert? That’s the Roth Question

Nearly 20 million U.S. households have a Roth IRA — a significant number considering that it has been around only since 1998. However, Roth IRA participation still lags behind that of traditional IRAs, which were first introduced in 1974.¹

The good news is that you can invest in more than one type of IRA (the combined contribution limit in 2012 is $5,000, or $6,000 for those aged 50 and older). And regardless of your income, you can convert all or part of your traditional IRA investments to a Roth IRA and benefit from tax-free withdrawals in retirement.

Paying Taxes Now or Later

Contributions to a Roth IRA are made with after-tax dollars (subject to income limits), whereas contributions to a traditional IRA are generally tax deductible. When you withdraw money, however, qualified distributions from a Roth IRA are free of federal income tax if you’ve satisfied the requirements (distributions may be subject to state income taxes). By contrast, traditional IRA withdrawals are taxed as ordinary income.

When you convert tax-deferred IRA assets to a Roth IRA, the conversion amount is taxed as ordinary income in the tax year of the conversion. This can be a significant expense, but there’s a trade-off: Under current tax law (and if all conditions are met), the Roth account will incur no further income tax liability for the rest of your lifetime or for the lifetimes of your account beneficiaries, regardless of how much growth the account experiences.

Here are some considerations to help determine whether a Roth IRA conversion might be appropriate for you.

Changing tax brackets. The logic behind deferring taxes on retirement savings is that investors may be in a lower tax bracket in retirement than they were during their working years. This is not always the case, of course, so you need to consider your own situation. Also keep in mind that tax rates are scheduled to increase after 2012 (unless Congress takes further action), so you may pay higher tax rates in the future.

Mandatory distributions. Unlike the case with traditional IRAs, there are no required minimum distributions (RMDs) at age 70½ for original Roth IRA owners, so you can keep money in your account until you need it, or bequeath it to your heirs if you wish (IRA beneficiaries must take RMDs). The longer your investments can pursue growth, the more advantageous it might be for you and your beneficiaries to have tax-free withdrawals.

Current value versus growth potential. If your tax-deferred assets have fallen in value over the last few years, one silver lining is that taxes on a conversion may be lower. Again, your choice on converting may depend on how much time your portfolio will have to pursue growth.

Keep in mind that you can convert as much or as little of your traditional IRA assets as you wish, and you can even spread the conversion process over a number of years to help manage the tax liability.

Traditional and Roth IRA withdrawals prior to age 59½ may be subject to a 10% federal income tax penalty. To qualify for a tax-free and penalty-free withdrawal of earnings, a Roth IRA must meet the five-year holding requirement and the distribution must take place after age 59½ or result from the owner’s death, disability, or a first-time home purchase ($10,000 lifetime maximum).

A Roth IRA conversion may not be an appropriate strategy for everyone, but it’s worth considering depending on your personal situation, time frame, and current and future tax brackets.

1) Investment Company Institute, 2011

The information in this article is not intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent Naperville Tax Accountant. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Emerald. Copyright © 2012 Emerald Connect, Inc.

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