Tax Diversification: How to Convert to a Roth IRA

Sadly, planning for retirement is never as simple as it should be. Budgeting your finances to save money is just the first step. A more difficult decision, however, is where to put the money for retirement.

There are several different types of retirement plans to consider, but the best one for some people is the Roth IRA. If you have your money stored in a different type of retirement account, don’t worry — it’s difficult, but you are indeed able to convert your retirement funds to a Roth IRA.

Why a Roth IRA?

The Roth IRA is a fairly new option for investors. The idea for this type of retirement plan first floated back in 1989 by U.S. Sen. William Roth, but it wasn’t enacted until 1997. Now, the Roth IRA is even more popular than the Traditional IRA, which was formed back in 1974.

The reason for the Roth IRA’s fast growth is both in its simplicity and tax structure. Roth IRAs are tax-free, so you won’t have to pay a dime in taxes when you hit retirement age and start withdrawing. The downside is that contributions can’t be deducted from your taxes — like with the Traditional IRA — but most people see that as an acceptable trade off.

People with Roth IRAs are in good company. One study found that smart investors are more likely to invest in a Roth IRA.

To see if switching over makes sense for you, try out this free calculator from Fidelity. There are some tax implications from switching, so make sure you have a good idea of the potential costs before transferring your money.

A quick note to high earners before we dive into the process — you might not be eligible to contribute to a Roth IRA if you’re earning more than $132,000 as an individual or $194,000 as a couple. However, you are able to roll over your traditional IRA into a back-door Roth IRA conversion.

How to Make the Switch

If you opened up a Roth IRA from the beginning, you’re in good shape. If your money is in a 401K or a Traditional IRA, then you’ll have to complete a few steps before your money is in a Roth IRA. Fortunately, the biggest brokerage firms make it an easy process.

All you really need is to notify your bank or brokerage firm that you wish to transfer to a Roth IRA. You can either stay with your existing institution or switch elsewhere. This is a matter of personal preference, but the easiest thing to do is to stay with where you’re already investing. Then, you specify how much you want transferred, fill out some paperwork, and the money will be on its way.

This part of the process is the easy part. The hardest part is calculating the potential tax hit from transferring, but there are some ways to mitigate the taxes. For starters, you can slowly transfer the money so you’re not dealt a massive one-year tax bill. You can also determine if some funds in the account are taxable and some aren’t.

In a sense, transferring to a Roth IRA is as simple as making a few clicks. The hardest part is ensuring you’re fully aware of the tax hit and have taken steps to mitigate the cost.

Worth the Effort

The potential tax hit might give some investors pause when they’re deciding whether to transfer to a Roth IRA. However, that one-time hit could be worth the cost over time if you’ve done your homework properly. There are some situations when a Roth IRA isn’t the best course of action, so don’t rush into anything too quickly.