One of the keys to maximizing your pension savings is choosing the right pension account to begin with. Traditional and Roth IRAs are both good retirement savings cars, but the right thing for you depends on your own timeline and where you expect to be financially retired.
Traditional IRAs are subject to tax so your contributions will reduce your taxable income in the year you make them, but you pay taxes on your original contributions and any interests you have earned when you retire. Roth IRA contributions do not reduce taxable income in the year you make them, but you do not have to pay tax on any of the withdrawals.
The idea of tax-free distribution is appealing because you will be able to keep more of your pension savings for yourself than to give it back to the government and it leaves many asking questions to convert their traditional IRA into a Roth IRA. I discuss the advantages and disadvantages of this strategy below to help you figure out if it's your best move.
Reasons to Make a Roth Conversion
If you think your earnings are getting higher in retirement than it is today, it makes sense to keep your money in a Roth account. This may be the case for younger workers who are just beginning their careers and are currently earning a low salary. It is possible that income from social security schemes and pension accounts can put them into a higher income tax in pension than they are today.
Of course, it is impossible to predict exactly what your earnings will be or how your income tax brackets can change over time, so you can just base your decision on your best guess. If you think there is a good chance that you could end up paying less in taxes if you paid it now, instead of waiting for retirement, you may want to do a Roth IRA conversion.
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Traditional IRA has required minimum distribution (RMD) when you reach 70 1/2. This is the government's way of ensuring that it receives tax revenues from the funds. RMDs are determined by your age and the value of the IRA. You can calculate your using this spreadsheet.
Roth IRAs, on the other hand, have no RMDs because you have already paid tax on the money, so you can add it to your account as long as you want, and it will continue to grow. If you send your account to your heirs when you die, they will not have to pay any tax on the money either.
Reasons Not to Make a Roth Conversion
If you think you are in a higher income tax bracket now than you want to be in retirement, a Roth IRA conversion is not a smart choice. This is usually the case for adults who are at the top of their careers. When you make a conversion, you are taxed on all the money in the year you complete the conversion. If you are in a higher income tax, you might end up giving much more of the savings back to the government than if you had just left it in your traditional IRA and paid your taxes in retirement.
You also need to make sure you have the money to hand to cover the additional taxes in the year that you make the conversion. If you are under 59 1/2, you will not be able to use any of the funds in your retirement accounts unless you want to pay a 10% early repayment penalty on top of your income tax. So you have to have extra money set aside in savings. Keep in mind that the Roth conversion can push you into a higher income tax bracket for the year so you can end up paying even more than you expected. However, this strategy will help you reduce your RMD and retirement income tax so that extra tax this year may be worth these long-term benefits to anyone.
You should be aware that it is a five year period with Roth conversions. It starts January 1 of the year you make the conversion. If you withdraw any earned interest before this holding period is up, you may end up paying tax on that amount even if it is in a Roth account. But if you do not intend to touch the retirement savings for a few decades, this may not be a problem.
Roth conversions are also permanent in 2018, so you can't reverse this decision later if you decide it was a mistake. For this reason, it is important to consider this decision carefully. If you decide to go through the Roth conversion, all you have to do is contact the IRA management company and request that the funds be converted to a Roth IRA.