Should you convert your traditional IRA or 401k to a Roth? Or are you better off sticking with what you already have?
Either way, you stay plugged into the same powerful, wealth-building advantage that makes an IRA such a good thing to have—continuous compounding of investment returns unhindered by the drag of taxes.
Inside an IRA, all your earnings, 100%, get reinvested every year, year after year, for a faster build-up of wealth.
It’s when you take money out that a Roth IRA treats you very differently than a traditional IRA.
Traditional IRA vs. Roth IRA
Except for any non-deductible contributions you might have made, withdrawals from a traditional IRA are taxable. So a large share of every withdrawal is lost to the tax collector.
Withdrawals from a Roth IRA, on the other hand, are tax-free, provided the plan is at least five years old and you wait until the year you reach age 59½.
Just pay attention to the calendar and every penny you get from a Roth is really yours.
Roth World is clearly a sweet place for your portfolio to live and grow. But getting it there can be expensive, which is why the Roth decision can be hard to make.
It’s a Big, Taxable Step… and Worth It
You are free to convert a traditional IRA to a Roth IRA at any time.
There are no age requirements (either for you or for the plan), and there are no income tests to meet. The conversion door is wide open. It’s a big financial step, though.
Those contributions you have deducted as well as accumulated investment returns would pop out as taxable income. This means converting any part of a traditional IRA to a Roth triggers an immediate tax bill.
Do it anyway. Unless you’re confident you are destined eventually for a much lower tax bracket, paying the tax bill for converting to a Roth now is almost certainly the right move… but only to the extent you are able to pay the bill out of assets you own directly.
Here’s the logic.
Let’s suppose, for the sake of simplicity, that you are in a 40% tax bracket (state and Federal) and that you always will be. Regardless of investment performance and regardless of how long you wait to make withdrawals, 40% of what comes out of your traditional IRA is already tagged as government property. What you get is the remaining 60%.
In other words, a traditional IRA is a partnership between you and the government. If, for example, there is $1 million in that IRA, your real share is $600,000. The government already owns the other $400,000.
When you convert to a Roth, you are buying out your partner. Then you own the whole thing.
To see what you gain by converting, look at the effect on your overall portfolio.
The conversion doesn’t change how much you really own, it just reorganizes things. It shrinks the pool of assets that are earning taxable income (you drew them down to pay the tax bill), and it expands the pool of IRA assets earning income that is tax-free and 100% yours.
The reorganization will cut your tax bill year after year.
The same financial reasoning applies to converting a traditional 401k to a Roth.
Another Reason to Love Roth
The taxes you save with an IRA depend on (1) the IRA’s size and (2) the IRA’s longevity. Roths stay fat longer. A traditional IRA must start paying you (and depleting itself) when you reach age 70½.
A Roth isn’t subject to any such rule. It can continue accumulating tax-free wealth for as long as you like. You’re not forced to tap into it before you want to.
And you shouldn’t want to until you really need to, when you’ve exhausted all your other liquid assets. Until then, it is better—your lifetime tax burden will be less—if you spend from assets that generate taxable income (the investments you own directly) instead of from the no-tax investments inside your IRA.
Your Estate-Planning IRA
Because your IRA should be the last thing to touch when you need cash, you’re not likely to spend it down to zero. Some investors never spend any of it.
Serious thinking about how to maximize the usefulness of your IRA leads to some surprising results. Because an efficient IRA strategy likely means not spending the whole thing, an IRA isn’t just a retirement vehicle.
It is also a tool for estate planning and for much more that you haven’t yet noticed.
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