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July 18, 2022

Roth Conversions are getting a lot of attention

Some consider the drop in the markets maybe a good time for some to consider converting traditional IRAs to Roth IRAs. The withdrawal of the assets from the traditional IRA would be taxed currently. The resulting tax would be lower as the value of the investment would be lower. The future growth of the assets would not be taxable in the Roth or to the beneficiaries of the Roth. There are many assumptions and conditions to achieve the desired benefits. 

Tax rate assumptions

One assumption is that you will be in a lower tax bracket when you retire. A related assumption is that the tax laws will not change when the funds are distributed from the Roth. One approach would be to calculate your tax based on various assumptions. Depending on your current tax bracket and assumed future tax brackets to see how much to convert now.

Future values

There is a risk that the value of the investment will not grow or will drop in value.

Two five-year tests

To qualify for  tax-free and penalty-free withdrawal of earnings, including earnings on converted amounts, a Roth account must meet a five-year holding period beginning January 1 of the year your first Roth account was opened, and the withdrawal must take place after age 59½ or meet an IRS exception. If you have had a Roth IRA for some time, this may not be an issue, but it could come into play if you open your first Roth IRA for the conversion.

Assets converted to a Roth IRA can be withdrawn free of ordinary income tax at any time, because you paid taxes at the time of the conversion. However, a 10% penalty may apply if you withdraw the assets before the end of a different five-year period, which begins January 1 of the year of each conversion, unless you are age 59½ or another exception applies.

Roth account are not subject to Required Minimum Distributions (RMD)

Roth IRAs are not required to minimum distributions.  Distributions are tax-free to the original owner of the Roth IRA and spouse beneficiaries who treat a Roth IRA as their own.  Other beneficiaries inheriting a Roth IRA are subject to the RMD rules. The longer your investments can pursue growth, the more advantageous it may be for you and your beneficiaries to have tax-free income.

There are many considerations and assumption in determining if a Roth Conversion is appropriate for anyone. The above is not intended as a complete discussion of the subject. A trusted advisor should be consulted to see if a conversion should be considered .

All investing involves risk, including the possible loss of principal, and there is no guarantee that any investment strategy will be successful.

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