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December 8, 2013

Should you convert to a Roth IRA?

(Continued)

2. Source of funds to pay conversion taxes: Where will the money come from to pay income taxes on the amount converted? The source of these funds is important because if you pay the taxes from your traditional IRA or another retirement account you will lose the potential benefits of tax-free growth on that amount. Also, if you’re under 59½ you will likely incur a 10 percent federal penalty. Some states may also impose their own “early withdrawal” penalties. Conversely, using taxable (non-retirement assets) to pay the conversion taxes in effect allows an investor to increase the total amount of tax-sheltered assets they hold in an IRA. For example, suppose an individual is considering a conversion of a $10,000 traditional IRA. At a 25 percent tax rate, the individual’s share of the IRA is $7,500 while the government’s portion is $2,500. However by paying the $2,500 in taxes from a taxable investment account, the Roth IRA will end up with a $10,000 balance, 100 percent of which is now the individual’s share.

In effect the conversion from a traditional to a Roth, with the resulting taxes paid from a non-retirement account allowed the investor to shift $2,500 from a taxable account to a tax-free Roth. Another way to describe this is to say that dollars in a Roth IRA are worth more than dollars in a traditional IRA because once you have paid your taxes from outside funds and “bought out the government’s share,” the Roth gives you tax-advantaged growth on “more” wealth.

3. Investment time horizon: Unlike a traditional IRA, with a Roth you are not required to begin taking minimum distributions at age 70½ or anytime during your lifetime. This means you can keep the money growing tax-free for a very long time. The longer you leave your money in your account the more time it grows tax-free and, therefore, the greater the chance of recouping the taxes you paid on the amount converted. In other words, the further the individual is from needing to withdraw funds, the more likely it is that conversion is a good idea.

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