Converting retirement funds to a Roth

I recently received a letter asking me for more information on Roth IRAs. The writer questioned why financial pundits recommend the Roth if you inherit a large estate and wondered about converting a traditional IRA to a Roth IRA.

IRA is short for individual retirement account. Many things can be used in retirement to provide income, but in this column, I will discuss accounts that the IRS recognizes and gives special tax treatment.

Most retirement accounts allow you to put money into them tax-free. The down side is when you retire, you must pay the tax on the money you deposited plus any growth earned in the account.

For example, $50,000 deposited plus $50,000 growth from retirement investments will be taxed at $100,000. A Roth IRA does the reverse: Contributions are taxed at deposit. However, when the money is withdrawn, no tax is due, plus there is no tax on the growth.

There are two main reasons why one would convert a traditional retirement plan to a Roth IRA. First is a belief that your tax bracket will be higher in retirement than it was while employed. Second is a belief you will not need the money in retirement and want to pass it on to your heirs. A Roth IRA allows you to avoid required minimum distributions (RMD). Today all pretax retirement accounts require that you start taking RMDs at age 73.

Converting a traditional retirement account has tax implications. The money in your traditional retirement account has not been taxed. The amount you'll pay depends on your marginal tax bracket. Understand that the amount you convert can also increase your marginal tax bracket.

Converting a traditional retirement account and using part of the funds to pay the tax will reduce your end results and is rarely advised. For example, $50,000 taxed at 20% leaves $40,000 in your new Roth account. The $40,000 will grow to $78,686.05 at 7% while $50,000 will grow to $98,357.57 in the same 10-year period.

It is important to know that one does not have to convert the entire retirement account. People follow a strategy of converting a portion of the traditional retirement account over a series of years. This strategy can help reduce the marginal tax rate and reduce the required cash needed to pay the taxes.

Inheriting a large estate and opening a Roth is dependent on what you inherited. Nonretirement accounts can be used to open a Roth, but income requirements still must be met. In 2024 you can contribute up to $7,000 into your Roth, and if you are over 50 the amount is $8,000. These limits also can change if you have another retirement plan and have income over $146,000 if you are a single filer or $230,000 if married filing jointly. Also remember you can open a spousal Roth if you are filing jointly, which can double your savings.

If you inherit a Roth you can maintain it but there are rules on distribution, such as the Roth must be in existence for five years and how quickly you must liquidate the account.

The rules for inheriting any retirement account are complex and should be explained by a tax consultant. Do not cash it out until you fully understand the consequences.

Bob Hollick is a State Farm insurance agent in Washington. He welcomes questions and emails at Bob@Bobhollick.com.

Bob Hollick is a State Farm insurance agent in Washington. If you have a question, email him at Bob@Bobhollick.com/.