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Bottom Line Up Front

  • Traditional IRA contributions are made with pre-tax dollars, while a Roth IRA is funded by after-tax dollars. With a Roth, you can enjoy tax-free growth and tax-free distributions.
  • The tax advantages of a Roth IRA may sound attractive, but make sure you understand the tax consequences before you make the switch.
  • You’ll owe taxes on traditional IRA funds that you convert to a Roth, and you'll have to pay them for the same tax year.

Time to Read

5 minutes

May 2, 2022

At some point, you invested in an Individual Retirement Account (IRA). You likely chose a traditional IRA as part of your retirement planning. IRA assets can play a big role as part of your retirement savings, along with social security, workplace 401(k) balances and other investments. 

However, you keep hearing about the tax benefits of a Roth IRA and are curious what those tax advantages are. You may wonder if converting funds from a traditional IRA to a Roth IRA would be the best decision for you. Let’s take a look:

Fundamental Differences: Traditional IRA vs. Roth IRA

First, make sure you understand the tax advantages to both types of IRAs—and the tax consequences. A Roth IRA offers a different set of tax advantages than a traditional IRA. 

With a traditional IRA, you are effectively investing pre-tax dollars because you can deduct those IRA contributions on your federal tax return for the same tax year. You get a tax benefit up front while your money potentially grows tax-deferred over time, based on your investment choices. In 2022, the Internal Revenue Service allows you to contribute up to $6,000 ($7,000 if you’re 50 or older), and you can deduct that amount from your taxable income the same tax year. That helps reduce your tax bill in the short term.

With a Roth account, you make your IRA contributions with after-tax dollars. And, even though you can’t deduct contributions on your federal tax return as you can with a traditional IRA, your money grows tax-free and can be withdrawn tax-free in retirement. That’s a big benefit that isn’t available with a traditional IRA. 

Paying Taxes on the Roth IRA Conversion

If you have a traditional IRA but like the idea of tax-free growth and withdrawals, then why would you ever hesitate? Because, when you convert your traditional plan to a Roth, you have to pay taxes on it since you didn’t pay taxes on that money when you first contributed it. And, the taxes will be due for the same tax year of the conversion. 

Additionally, if you are age 72, you will have to take an annual Required Minimum Distribution (RMD) from your traditional IRA. This is necessary every year, and you’ll have to take that distribution before you can convert the funds. You’ll pay taxes on the RMD as ordinary income, as well. (Learn about the new RMD tables effective in 2022.)

These tax payments may give you pause, but it may be worth the current tax year pain to reap the tax benefits later.

A Roth IRA conversion may make sense if:

  • You’ll have low income or no other income in the year you’re converting. If you’re in a lower income tax bracket because of a layoff or time away from the workforce, converting now could save you money because you’ll pay less in taxes while your tax rate is lower. You don’t have to convert the entire balance either—you can convert any amount you choose.
  • You’ll retire in a higher tax bracket. No one knows what tax rates will be in the future, but if you believe yours will be higher after you retire, it may make sense to pay tax on the money now. That way, you can avoid paying a higher tax rate on withdrawals when you’re retired.
  • You want to pass tax-free money to heirs. Beneficiaries who inherit your Roth IRA won’t have to pay federal income tax on the withdrawals, as long as the Roth IRA account has been open five or more years. If it’s been open for a shorter period, they’ll owe tax but no penalty.

A Roth conversion may not make sense if:

  • You’re likely to need the money within five years. If you’re nearing retirement and expect to make withdrawals within five years, you’ll probably want to keep the traditional IRA because withdrawals from a Roth IRA are only tax-free if you’re age 59½ or older and have held the account for five years or more. If you withdraw the money sooner, you’ll not only end up paying tax, but you’ll also pay a 10 percent early withdrawal penalty. Plus, if you need to use money from the IRA to pay the conversion taxes, you’ll lose all future earnings on that amount. 
  • You expect your tax rate to drop. If you expect to have a lower tax rate when you retire, converting now might cost you more in taxes now than you’d save with tax-free withdrawals later. So, look at your tax bracket now and think about what it may be in retirement before you decide to go through with the conversion.

Roth and Traditional IRA accounts both have benefits that you should look at as part of your estate planning. If you still need some guidance, a tax advisor can help you walk through these scenarios in greater detail.

Next Steps Next Steps

  1. To read more about what the IRS has to say about traditional IRAs and Roth IRAs, review its consumer information on the basic differences between the IRA accounts. It even offers a tool to help you determine if your distribution from a traditional IRA, or from two other types called a SEP IRA or SIMPLE IRA, would be fully or partially taxable in a given year.
  2. Talk to one of our financial advisors today to get more information about these investment tools.

Disclosures

Navy Federal Financial Group, LLC (NFFG) is a licensed insurance agency. Non-deposit investments, brokerage and advisory products are only sold through Navy Federal Investment Services, LLC (NFIS), a member of FINRA/SIPC and an SEC-registered investment advisory firm. NFIS is a wholly owned subsidiary of NFFG. Insurance products are offered through NFFG and NFIS. These products are not NCUA/NCUSIF or otherwise federally insured, are not guaranteed or obligations of Navy Federal Credit Union (NFCU), are not offered, recommended, sanctioned or encouraged by the federal government, and may involve investment risk, including possible loss of principal. Deposit products and related services are provided by NFCU. Financial advisors are employees of NFFG, and they are employees and registered representatives of NFIS. NFIS and NFFG are affiliated companies under the common control of NFCU. Call 1-877-221-8108 for further information.

This content is intended to provide general information and shouldn't be considered legal, tax or financial advice. It's always a good idea to consult a tax or financial advisor for specific information on how certain laws apply to your situation and about your individual financial situation.