Timing is everything, especially when it comes to making the proper tax conversions for a retirement savings account.
Knowing how and when to convert a 401(k) to a Roth 401(k) investments or transition a traditional individual retirement account – better known as an IRA – to a Roth IRA can have big tax implications.
Tax triggers. When converting to a Roth IRA, the two most important considerations are the taxes owed on the conversion, since the converted amount is considered taxable income and if you have the funds to pay the additional taxes, says Benjamin Westerman, senior vice president HM Capital Management in St. Louis. His recommendation: Convert traditional IRAs to Roth IRAs if an investor's tax rate is at the 10 or 0 percent income tax bracket.
"If funds are in the 15 percent tax bracket, we generally recommend converting only if your future tax rate is significantly higher," he says. "If you expect your tax rate to be lower in the future doing a Roth conversion might not be the best option."
Free online Roth IRA conversion calculators can also help with finding the conversion rate, says James Liotta, president and owner of Prominence Capital in Beverly Hills, California.
[See: 10 Ways to Avoid the IRA Early Withdrawal Penalty .]
More importantly, consider the bigger picture. Many investors seek short-term deductions to help their business or individual tax rate without considering the long term, Liotta says.
"You want to put yourself into the best position for the most usable wealth in your lifetime," Liotta says. "Are you looking to build bigger and better long-term wealth or have a tax deduction right now? Not paying taxes now is short-sighted because it isn't building as much usable wealth in the long run."
An investor who is in their 40s or even older probably still has a compelling reason to convert to a Roth account , if their income is still expected to go up, coupled with the likelihood that taxes will increase and their tax rate might go up over time, Liotta says.
During retirement that could make a big impact.
"Your traditional IRA could have a larger number than someone who has a Roth IRA," Liotta says. "But the person who has the Roth IRA doesn't have to pay taxes on that amount and might end up having more usable money in the long run than the other guy who still has to pay taxes."
Pro and Cons of Contributing to a Roth IRA in Your 70s
Conversion methods. If you're thinking of doing a Roth IRA conversion, there's a couple options.
There's the rollover method, where a direct transfer, usually done when an investor leaves an employer, converts funds from plans such as a 401(k), Roth 401(k) or traditional IRA and rolls it over to a Roth IRA. This must be done within 60 days of the distribution and can only be done once within a 365 day period or the distribution will be taxable and subject to a 10 percent early withdrawal penalty if the investor is younger than 59.5.
Another transfer option is trustee-to-trustee. Also called an indirect rollover, this is when your investments from a former employer's 401(k) plan is sent to you first and then moved into an IRA account. This also must be done with 60 days or subject to penalties.
A same trustee transfer happens if the owner of your traditional IRA , such as a brokerage firm, transfers part or all of your traditional IRA to a Roth IRA. This can also be accomplished by redesigning the traditional IRA as a Roth IRA, rather than opening a new account, Liotta says.
Know the eligibility requirements. Not all investors can contribute directly to a Roth IRA if their income exceeds certain limits. For 2017, the phase-out for a single tax filer begins at $118,000 of adjusted gross income and $186,000 for joint filers. Once an individual investor makes more than $133,000 in AGI (or $196,000 for those who are married filing jointly), they can no longer contribute.
[See: 9 Ways to Avoid 401(k) Fees and Penalties .]
High-earners ineligible to make a Roth IRA contribution can circumvent these income limits by doing a "back-door" IRA. Investors make a contribution, that isn't deductible, into a traditional IRA and then convert the funds, after paying taxes, to a Roth IRA. This is possible because there aren't any income limits for converting a traditional IRA to a Roth IRA.
Investors who do this do not get a pre-tax deduction on the IRA contribution but the contribution grows tax-deferred , says Stephanie Bruno, a certified private wealth advisor for SBWA in Denver.
"When you withdraw funds you do not pay tax on the original principal contributed, only the earnings," she says.
Other considerations. Unlike a 401(k), Roth 401(k) or traditional IRA, there's no required minimum distribution on your Roth IRA when you reach 70.5 years old, an event which can cause many investors' tax rates to increase.
Roth IRAs can also become a tax-free transfer to beneficiaries or heirs when you pass away as long as the account has been open at least five years. It also won't cause your Social Security benefits to be taxed at a higher rate if your total income is $32,000 or less for married couples or $25,000 for single filers, says Noel Dalmacio president of Dalmacio Accountancy Corp. in Irvine, California.
Roth IRAs can also be used toward a first-time home purchase up to $10,000 or for qualified higher education expenses without penalties.
There are some benefits for converting to Roth 401(k) over a Roth IRA. The annual contribution limit is higher. In 2017, investors may defer up to $18,000 in a Roth 401(k) plus an additional $6,000 for participants 50 or older. That's a lot more than Roth IRA investors, who can contribute up to $5,500, or $6,500 for anyone 50 or older.
Unlike a Roth 401(k), a Roth IRA can be recharacterized, which means an investor can "undo" a conversion if you change your mind, says Laura Redfern an investment advisor representative at Shadowridge Asset Management in Austin, Texas.
"If you do the Roth conversions and your tax bracket went up substantially, your can do a recharacterization back to a traditional IRA to reduce your taxable income," Liotta says.
Timing is everything. Even though converting to a Roth is considered a taxable event, it doesn't have to be done all in one year or into a single fund. For example, if you want to make a $30,000 Roth IRA conversion, you could create three separate $10,000 IRAs and invest them into three different strategies, Westerman says.
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"If any of the investments lost money by Oct. 15 of the next year, you could do a reconversion of just that account," he says.
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