There are many differences between a Traditional IRA and a Roth. The biggest difference is the way each are taxed. In a Traditional IRA you contribute pre-tax dollars. You get a tax deduction now, but pay income taxes on your account withdrawals when you’re retired. On the other hand, in a Roth IRA, contributions are made with after-tax dollars. You do not get a tax deduction now, but all of your withdrawals – both principal and growth – are tax free. Pretty sweet, right? Well, did you know that you can convert your traditional IRA to a Roth?
If you’ve already started a traditional IRA or other deferred-tax investment plan, and want to convert it to a Roth there is no better time than now! When you convert your Traditional IRA to a Roth you are required to pay income taxes on the account balance in the same year you make the conversion. Taxes are never fun to pay, but there is probably no better time to have a big tax bill than now. Doing a Roth conversion when the market is down means your account is worth less, so your tax bill is smaller. Follow me…
Imagine you had a Traditional IRA that was worth $200,000 on January 1. If you’re in a 33% tax bracket, a January 1 Roth conversion would have cost $66,000 in federal taxes. However, if that same account lost a third of its value in the mid-March market crash it would be valued at $133,000. That means a Roth conversion during this same period would only cost $44,000 in federal taxes (assuming the same tax bracket). History suggests that your investments will recover their value in time, and when they do it will be in a tax-free account.
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