I have a rollover IRA just existing from a previous employer and my brother says I should get it converted to a Roth IRA ASAP. I have no clue what that even means and when I looked it up in here, it’s everyone just talking about what to investments are best for their Roth…so that means I convert to the Roth and have to figure out stocks to put it in? How do I decide what is best? I genuinely know nothing about this.
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Basically with a Roth IRA you’re using after tax dollars and taking care of your tax liability up front. This is advantageous as you’ll have to pay far less taxes this way.
A Roth IRA is a post tax retirement account that grows tax deferred. Once you reach the age of 59.5 and have had the account (with a contribution) for over five years, the gains on the account are withdrawn tax free.
There’s benefits in doing a Roth conversion. But know that you will pay taxes on converting a (presumably) pretax 401k into a Roth IRA. I’d talk with a tax professional or financial advisor before you make that decision to better understand the tax implications of the conversion.
A Roth works like this:
Basically: you take the tax-hits up front and sail smoothly when it’s time to retire! Whether or not that’s a good fit for you is entirely based on your own situation. 🙂
Traditional IRA is funded with pre-tax money and future withdrawals are taxed. Roth IRA is funded with post-tax money and future withdrawals are untaxed. Converting involves paying taxes now on the money moved over, but makes future withdrawals untaxed. I wouldn’t convert. I have a suspicion the government may renege on the tax free status of Roth withdrawals in the future.
Let’s say you have $100,000 in your rollover IRA and it grows to $1,000,000 when you retire. When you take the money out, you will pay taxes on it. Say those taxes are 25%. You will receive $750,000
If you convert to a Roth IRA now, you’ll pay taxes on the $100,000 today. Assuming the same 25%, that leaves you $75,000, which will grow to $750,000 in retirement, but you won’t pay taxes when you take it out.
Now, if your current rate is only 20% and you think the rate in retirement will be 25%, then you’re better off converting now. If your current rate is 25% and you think your rate in retirement will be 20%, then you’re better off waiting
(It’s more complicated than that, but that’s the very basic idea.)
Its not so straightforward as what your brother is saying.
Your normal rollover IRA that you have now is untaxed when you put money in now and is taxed later as income when you get it out (presumably when you retire).
Roth is different in that it is taxed first as income now and then it’s untaxed later when you get it out. There are definitely real benefits to this.
This means if you convert your whole IRA to roth now, you’ll face a huge tax burden up front because everything you are converting is treated as new income on top of your income you are already being taxed on this year. It could push you into a higher tax bracket on the year and make that money you are converting taxed at a high rate.
The best way to handle it is imo to try to diversify a bit. That way, lets say when you retire, in one year, your normal rollover could pay out 60k in one year, and your roth pays out another 40k, you’ll get 100k and only pay taxes on 60k of taxable income. This can keep you in a lower bracket at that time.
So basically you try to plan it such that you keep your “income” both now and when you retire in lower brackets. If your rollover is flush, you may consider trying to convert bits and pieces each year such that you dont push your income into higher brackets. If your rollover is not that loaded, it may not matter much anyway because when you make that “income” after retirement you wouldnt be in a high tax bracket anyway. You sort of have to project out the future and estimate your career earnings to make a good plan.
For retirement accounts, there are two basic types: traditional and Roth.
For a traditional retirement account, the money is taken out pre-tax. So if I make $100,000 and I take out $10,000 a year for my IRA, and my tax rate is 20%, I am only taxed 20% on the $90,000 remaining after withholding for the IRA, so I pay $18,000 in taxes and take home $72,000. Then, when I retire and withdraw money from the IRA, I am taxed on that as income.
For a Roth IRA, you pay the taxes upfront. So with the same $100,000 and $10,000 withholding, I am taxed 20% on the full $100,00, or $20,000, and have a net take-home pay of $70,000. The benefit that I get in return is that, when I retire and withdraw money from the Roth IRA, it is not taxed as income as taxes have already been paid on it.
If you take money from a traditional IRA and roll it over into a Roth IRA, you will need to pay taxes on that amount as you roll it over, meaning either some of that money doesn’t make it into the Roth IRA or you have to pay out of pocket.
As for which one you should prefer, that’s going to depend on some factors. Are you close to a tax threshold? Taxes in the US at least are graduated, so you pay a certain percentage on your first so many dollars made and a higher percentage on anything after that. If you’re making $200,000/year as a single taxpayer, it might make sense to withhold ~$9,000 for a traditional IRA as anything over $191,950 is taxed at 32% as opposed to the 24% that you are making between $100,525 and $191,950 so you get less of that last bit of money if you don’t withhold it.
Another factor to consider is whether you believe you’ll be paying a higher tax rate in retirement or currently. For most people, it’s likely that you’ll be paying lower taxes in your retirement years as you won’t be working a full career at that point, but if you expect to have a high enough income in the near future that you’ll have a lot of investments paying out in the further future, that may not be true. You may also suspect that tax rates will need to increase over time to compensate for federal deficit, so taxes right now are probably lower than they’ll be in 40 years.
Traditional IRAs and Roth IRAs are both retirement savings accounts with favorable tax treatment, but with different timing.
First, with an ordinary investment account, you can only invest money you have already paid tax on, and earnings are taxed as you go (interest and dividends immediately, capital gains when you sell the stock).
With a traditional IRA, the money you invest is tax deferred (you get a deduction in the year you contribute), and taxes on the investment profits are also deferred. You pay all the taxes when you withdraw the money. The 401(k) plan from your work follows the same rules, so when you change employers, the account is set up as a traditional IRA.
A Roth IRA (named for the senator from Delaware who introduced the law creating them) has its tax benefits on the far end. You get no deduction going in, but withdrawals are not federally taxed. Thus, the investment profits are never taxed by the feds (they may be taxed by a state).
A “Roth conversion” means you pay the tax on all or part of your traditional-IRA balance in the year(s) that you do the conversion, and get the future benefits of a Roth on that money. I say years, possibly plural, because you can convert part of the account in one year and part in another. This can be useful if your tax bracket would be affected.
Both plans have their pros and cons. Your best bet is to put your questions to the bank or investment house that is holding your IRA (they have experts on the tax and investment consequences, and are the only ones who know the mechanics of how a conversion is handled within their firm). If you already have your own tax pro, ask them too.
If you keep your Investment Retirement Account (IRA), all that money had been added to your 401K without being counted as income for tax purposes. You basically can leave the money as an IRA and it will grow without it being taxed. You are deferring your taxes until later. When you retire (age 59 1/2 is the government age for that purpose), you’ll get taxed on the money you withdraw from the IRA like any income. In theory, you’ll have less income in retirement so you’ll be at a lower marginal income tax rate so it’ll save you money because you are paying less in taxes plus all that money you would have paid as tax has been accumulating and earning more money.
If you want to flip into a Roth IRA, you’re changing the dynamic in one key way…. You go ahead and pay the taxes on all the money you have in your IRA at your current marginal tax rate. But as long as you adhere to the requirements; which generally means you have it in there for at least five years and don’t withdraw before you’re 59 1/2 years old, no matter what you earn, it is tax free.
So this is what you need to figure out; what makes more sense for you?
Do you have the money to pay the income taxes on all of your rollover IRA money?
Do you have enough time that you’d make a lot more from your investments to make up for what you had to pay now in taxes?
Will your tax rate when you are in retirement be high enough that withdrawing some of your IRA hurts if you have to pay taxes on it?
You might be able to just move a portion of the IRA to Roth, but that’s where an investment advisor would come in.