As discussions loom about rising income tax rates, many Americans are turning their attention to tax planning. The decision to convert a traditional IRA to a Roth IRA, like most planning decisions, is very personalized. Before weighing the advantages and disadvantages of a conversion, it may be helpful to review the differences in how traditional IRAs and Roth IRAs are taxed. Contributions to traditional IRAs were made with pre-tax dollars, contributions and earnings grow tax-free, and distributions are tax-free. Both traditional IRAs and Roth IRAs are subject to early withdrawal penalty taxes.
Your Current and Expected Income Tax Rate
The most significant consideration in converting part, or all, of a traditional IRA to a Roth IRA is the conversion may allow you to pay tax now on the traditional IRA rather than later, if you expect that your marginal tax rate will be higher in the future. If you pay the tax now, all growth and earnings from the Roth IRA will not be subject to further tax. Conversely, if your marginal tax rate is expected to be lower in the future, conversion to a Roth IRA may not be advisable. Many retirees may experience a lower tax rate in retirement, after earned income ceases.
Tax Payable at Conversion
When a traditional IRA is converted to a Roth IRA, the income tax on the converted assets will be included on your tax return for the year of conversion. Plus, if you are under the age of 59½, the additional 10% early withdrawal penalty will apply. Ideally, you should have the cash available to pay the tax, from outside the IRA, instead of using the assets from the IRA. This will allow you to maximize the growth of your new Roth IRA assets. Also, be aware that you may pay more tax on your Social Security income and higher Medicare premiums if the converted assets, added to your other taxable income, put you in a higher tax rate.