All too often I talk to people who don’t want to convert their regular retirement account to a Roth IRA account because they have to pay taxes. I think this is “wrong thinking” and I’ll tell you why.
First, let’s review retirement plans:
Social Security is a retirement plan. Money is taken out of your paycheck while you work, and when you are in your 60’s you receive a monthly payment based on how much you have contributed. Some or all your of your payment may be taxed depending on your income.
Company Retirement Plan. In the past, companies provided pensions similar to Social Security. Now, most offer retirement plans like a 401(k). The employee contributes money each paycheck, and the company may or may not match part of that contribution. The money you contribute is deducted from your taxable income, and you pay no taxes until you take it out.
Individual Retirement Plans (IRAs). These work like 401(k)s. The money you put in is “tax deferred,” i.e. you only pay taxes when you take it out during retirement.
Introducing the Roth IRA. In a Roth, you pay taxes on your contributions now, and you are never taxed again on either the money you put in or on the growth of that money. Roth money is not considered part of the Required Minimum Distribution when you reach 70 1/2. It is possible to “convert” a regular retirement account into a Roth account, but you must pay the taxes on the converted amount. The biggest advantage of the Roth is you never pay taxes again. This fact trumps paying taxes now. People should change their thinking about paying taxes on a Roth conversion:
#1 – Taxes are lower now than they have been in generations. Despite the current political rhetoric, I think taxes will be higher in the future. Isn’t it better to pay lower taxes now rather than higher taxes in the future?
#2 – When you put money into an IRA or 401(k), it is “tax deferred.” When you are paid now, you do not receive your full salary, some is withheld for taxes. Consider money in your retirement account to be future salary. You take your future salary and you pay the taxes. If you look at it like this, you will not have the aversion to paying taxes for a Roth conversion.
Converting all the money is your retirement account into a Roth at one time is not a good idea because it will push you to a higher income tax category. Do a manageable amount each year.
Think differently about a Roth conversion.
Other articles by this contributor:
Retirement Age and Can’t Retire. Don’t Let This Happen to You
What My Family Should Know – a Guide to Estate Planning
How to Prepare for Retirement