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Is paying taxes on a Roth conversion worth it?

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Roth IRAs entice savers with their promise of access to contribution dollars and the potential for tax-free earnings in retirement.* So as you stay on the lookout for ways to save more money in the long term, it may make sense to consider converting your traditional IRA to a Roth IRA.

But there's a key factor to consider: Are the tax implications of a Roth conversion worth it? The money in your traditional IRA is tax-deferred, but that money will be subject to tax if you convert to a Roth IRA.

Let's take a deeper dive into Roth IRAs, the taxes involved and how they might affect your finances.

Why Roth IRAs are special

Roth IRAs are popular because of their unique tax advantages. Unlike traditional IRAs, Roth accounts are funded with money you've already paid taxes on. That means your contributions are available tax-free. In addition, as your earnings compound over time, if you meet certain requirements, you can withdraw those without ever paying taxes on them.*

These features make the Roth IRA a smart way to minimize tax liability during your retirement years.

If you're considering converting funds from a traditional IRA to a Roth IRA, however, be aware that you're going to have to pay some taxes if you make the switch.

How taxes come into play on a Roth conversion

Because traditional IRAs are funded with pretax dollars—money you haven't yet paid taxes on—you'll have a tax liability after you convert those assets into a Roth IRA. In other words, the taxes you got a break on when you put money in your tax-deferred traditional IRA will be due.

Your Roth conversion is treated as ordinary income and taxed accordingly. So be prepared to have the money on hand to pay the tax bill.

Estimated tax installments vs. one-time payment

Depending on your financial situation, you can approach that tax payment in two ways:

Your first option is to make estimated tax payments on your Roth conversion during the year. Spreading out these tax payments can help you manage cash flow. However, it requires you to figure out how much tax you'll pay on a Roth conversion, which may require assistance from a tax professional.

Your second option is to wait to pay your Roth conversion tax bill when you file your annual tax return. This is a more straightforward choice. However, if you don't have the money set aside, a hefty one-time payment could strain your finances.

Be sure to avoid an underpayment penalty on taxes due

Waiting until you file your return also can result in you owing an underpayment penalty. The IRS has a pay-as-you-go system, meaning you must make payments throughout the year as you earn income rather than waiting until you file your return.

To avoid an underpayment penalty, make sure your estimated tax payments and any withholding from other income will cover at least 90% of the tax due for the current year or 100% of the tax shown on the previous year's return. This amount increases to 110% if the adjusted gross income on your prior year's return was over $75,000 as a single filer or $150,000 if married filing jointly.

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Consider spreading out your Roth conversion to potentially reduce your tax bill

A way that may reduce your tax bill is to move your traditional IRA assets into a Roth account in smaller chunks over several years rather than converting to a Roth IRA all at once. This strategy can potentially reduce your tax bill by keeping you in a lower tax bracket.

However, one factor to take into account is the five-year rule. It requires you to let your money sit for five years post-conversion. If you need to withdraw funds before the five years is up, you'll typically owe penalties on withdrawals of earnings unless an IRS penalty exception applies. It restarts with each conversion you make, so you would need to keep track of multiple conversion dates.

When a Roth conversion might make sense

Given the tax implications, why consider a Roth conversion? In some cases, the benefits outweigh the costs—especially if you're in a low tax bracket now and anticipate having to pay higher tax rates in the future.

Here's a look at situations that might make a Roth IRA conversion appealing:

  • Low-income years. Consider a Roth conversion if your income is unusually low this year, perhaps due to a layoff or a down market.
  • Retirement predictions. If you expect higher income in retirement, a Roth conversion now might save you significantly on taxes in the future.

How a Roth conversion works

After you've weighed the pros and cons of converting to a Roth IRA and have decided to move forward, it's a pretty straightforward process. First, you need a Roth account. If you already have a Roth IRA, you can transfer your converted assets into the existing account. Otherwise, you need to open a new account.

Next, contact your financial institution(s) to see what they need to transfer funds from your traditional IRA to a Roth IRA. Each financial institution has its own forms and processes. Once you submit the paperwork, the conversion should occur within a week or so.

Afterward, as outlined, you need to pay income taxes on the converted amount. At the start of the new year, your financial institution will send you a Form 1099-R showing the amount converted. You'll use the information on this form to prepare your tax return, including Form 8606. This form notifies the IRS that you've converted your account to a Roth.

Plan your Roth IRA conversion thoughtfully

Deciding to make a Roth conversion involves strategy and timing. Understanding and leveraging the tax implications can open doors to a tax-efficient retirement. For tailored advice and guidance, connect with a local Thrivent financial advisor. They can walk you through the nuances and help you make an informed decision based on your individual circumstances.

*Distributions of earnings are tax-free as long as your Roth IRA is at least five years old and one of the following requirements is met: (1) you are at least age 59½; (2) you are disabled; (3) you are purchasing your first home ($10,000 lifetime maximum); or (4) the money is being paid to a beneficiary.

State tax rules may differ from federal rules governing the tax treatment of Roth IRAs, and there may be conflicts between federal and state tax treatment of IRA conversions. Consult your tax professional for your state's tax rules.

Thrivent and its financial advisors and professionals do not provide legal, accounting or tax advice. Consult your attorney or tax professional.