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As inflation rises and potential tax rate increases in new legislation occur, you may be wondering if now is the time to convert your traditional individual retirement account traditional (IRA) contributions to a Roth individual retirement account (Roth IRA). While these conversions may be a way to manage your effective tax rate while providing yourself with some flexibility for early retirement, a conversion may not always be the appropriate choice for every IRA holder. Here are a few situations where it may make sense to convert your after-tax contributions to a Roth IRA.
Reason No. 1: You Are Expecting a Higher Future Tax Rate
If you are in a relatively low tax bracket now but hope to have more income in retirement, your retirement income may have a higher tax rate than today's income. This circumstance is especially common among those receiving the Earned Income Tax Credit (EITC) or who have significant child tax credits. If converting your IRA contributions to a Roth IRA might allow you to stay in the lower tax brackets for the current tax year, it may be a viable way to manage your future taxes.
Reason No. 2: Your Retirement Funds Are Locked Up
Having all your retirement funds in a 401(k) or traditional IRA may make it tough to retire early. You may not be able to access these funds until you are age 59 1/2. Needing funds earlier may mean paying taxes and a penalty.1 Roth IRA contributions, on the other hand, might be more flexible and allow for penalty-free early withdrawals under certain circumstances.
Reason No. 3: You Are Facing Expenses in Your 50s
A Roth IRA has more flexible withdrawal rules than many other types of retirement accounts. Plus, it may provide a way to pay for expenses in your 50s and early 60s. For example, if you contributed $50,000 to your IRAs over the last decade, you may withdraw the entire $50,000, tax-free, to buy a new car, pay for your child's tuition, or even to pay off your mortgage.2
Reason No. 4: You Are Hoping To Leave Your Heirs a Tax-Free Inheritance
If you would like to mitigate taxes for your children or other heirs, passing down your Roth IRA could be worth considering. Someone who inherits a Roth IRA may have to take the required minimum distributions from the account but may not be subject to any federal income tax on these withdrawals.
While there may be many good reasons to convert a traditional IRA to a Roth IRA, there is no simple answer for conversions. It is always good to discuss this prospect with your financial advisor before considering a conversion strategy.
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