One common myth about retirement is that once you stop working, you’ll no longer have to pay taxes. Retirees face many expenses in retirement, and taxes may represent one of the largest. You may face tax obligations for things like pension payments, Social Security benefits, investment gains and more.
If you’re not careful, you could find yourself paying more taxes than necessary. Without proper planning, your tax bill could limit your ability to live a comfortable and enjoyable lifestyle. But with a strategy in place, you can take steps to minimize your tax liabilities in retirement.
One interesting tool is a Roth IRA. The Roth IRA has a unique tax structure that allows it to generate a tax-free income stream in retirement. That’s a direct contrast to the traditional IRA, which generates taxable distributions. The good news is that if you already have a traditional IRA, you can convert it to a Roth. Below are a few things to know about a Roth conversion and how it could benefit you:
What is a Roth conversion?
Quite simply, a Roth conversion involves transitioning your traditional IRA to a Roth IRA. There are a few reasons why a Roth conversion is appealing. One of the biggest is the Roth’s unique tax advantages.
In a traditional IRA you are able to deduct upfront contributions from your taxes. Taxes are also deferred on the growth of the account, which means you can put money into a traditional IRA, let it grow and not have to pay taxes on any of your gains as long as the funds stay in the account.
The downside to a traditional IRA? When you withdraw funds from your traditional IRA in retirement, you’ll have to pay taxes on those distributions. In essence, a traditional IRA gives you tax benefits now in exchange for a tax liability later in life.
In contrast to a traditional IRA, a Roth IRA has no upfront tax deductions. Once in the Roth, your funds will grow on a tax-deferred basis, just as they do in a traditional IRA. That means, similar to if you have a traditional IRA, you won’t have to pay taxes on your gains. However, after you reach age 59½, withdrawals from a Roth IRA are tax-free.
If you are thinking about doing a conversion, it’s important to keep in mind that you’ll have to pay taxes on the converted amount. This may mean you’ll have to pay a large lump-sum tax payment today. However, the prospect of tax-free retirement income in the future may make the tax payment worthwhile.
Benefits of doing a Roth conversion.
Converting to a Roth has several upsides. For example, doing a conversion can create a source of tax-deferred growth and tax-free income in retirement. That could free up room in your budget and help you live in retirement with more financial stability.
You also aren’t required to take mandatory distributions from a Roth. Unlike with a traditional IRA, which requires you to start taking taxable distributions at age 70½, you can keep your money in a Roth as long as you want. The funds can continue to grow tax-deferred indefinitely. In the event of your death, the funds in a Roth are also passed completely tax-free on to your beneficiaries.
Thinking about a Roth conversion? Let’s start a conversation. Give us a call at Bridge River Advisors and discuss your goals with a financial planning professional today.
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