In years past I’ve written about end of year tax tips. Many of those tips still apply, so they are worth a review. Just be sure to check updated information at irs.gov. This year I thought I’d take a different approach and examine one year-end question in particular: “Should I convert my IRA (individual retirement account) into a Roth IRA?” You’d have to act fast to implement this change before the end of 2013. However, for some of you Roth conversion could mean big savings.
A while back I wrote an article explaining the difference between an IRA and a Roth IRA in case you need a refresher. Below are some items to consider so that you can determine if converting to a Roth IRA is best for you.
Is 2013 a year you had lower income than normal? Are you likely to have higher income in coming years? In other words, you’re trying to assess if your tax rate now is likely to be lower than your future tax rate (when you’d be making withdrawals from a retirement account). This is important because you will be paying tax now on the funds you convert. According to Michael Kitces this is the single most important factor in the Roth conversion decision. Lower income (and therefore a lower tax rate) is often the case for someone at the beginning of their career.
Do you have money available in an after tax account to pay the tax bill? To make the conversion most effective, you want to maximize the amount of money that is growing within the Roth IRA. That means, paying the tax bill with funds outside the retirement account. That said, the funds I speak of are not in your emergency account. Perhaps you will be receiving a year end bonus that can help offset the tax bill or maybe you have other resources. Paying with after-tax money, instead of from the Roth account, is another factor to consider when deciding to make a conversion.
There are other factors too. This CNBC article on year end planning states that, “Ideally, investors should maintain multiple types of retirement accounts that they can use for a variety of objectives. This includes having a Roth IRA.” It’s important to note you can convert a portion of an existing IRA to a Roth IRA so it doesn’t have to be all or nothing. Having a Roth IRA along with a 401(k), IRA or similarly taxed account offers you the greatest number of planning options. Think of it as a hedge against the unknown changes in future tax legislation. A Roth IRA, gives you flexibility that other accounts don’t. For instance, you can take principle out without penalty in some circumstances, and you don’t have to take required minimum distributions in retirement. You can potentially benefit from continued deferred growth of the account.
Time is running out to make a conversion from an IRA to a Roth IRA in 2013. Consider your circumstances and make a decision that is right for you before the end of the year, so that you can continue to SaveUp!
This post was written by SaveUp’s personal finance contributing writer, Catherine Hawley, CFP®.
Image source: Forbes