The two options raise the obvious question: Would you rather pay tax on the seed money now or the crop of money later? This point has been debated for years, but for this post we are going to assume you would rather pay the known tax now vs. an unknown tax later.
Many people with traditional IRAs also open and fund a Roth IRA. But, if you'd like, you can convert a traditional IRA into a Roth account. Taxes are due on any amount you convert. The benefits of conversion:
- Tax-free qualified distributions.
- Tax-free growth of earnings.
- Uncertainty of future tax rates eliminated.
- Lower taxes owed on retirement benefits, such as Social Security
- No required minimum distributions.
- Possible larger estate to leave behind for heirs.
Partial Conversions Can Be Powerful
Many people don't realize that they can convert just a portion of a traditional IRA. If you combine the partial conversion with certain financial products, your tax burden can be lessened dramatically.
Let's assume you have $400,000 in a traditional IRA and your effective tax rate is 20 percent. You initiate a partial conversion of $130,841, which would mean you have to pay $26,168 in taxes. This gives you $104,673 for your Roth account and leaves you $269,157 in your traditional IRA.
You could elect to combine the conversion with a rollover into a solid fixed indexed annuity that offered a initial premium bonus. If you roll over your $269,159 traditional IRA into a product that gave you a 7 percent premium bonus and did the same thing with your new Roth account with a balance of $104,673 after taxes, then you would receive a $26,168 bonus that would put your starting balance of your combined IRA accounts back to the original $400,000 before the conversion.
The difference is that now $104,673 is now tax-free and not just tax-deferred. Assuming a modest 5 percent growth rate inside of both accounts, after just 10 years, you would be $43,785 ahead with this strategy than if you just let your traditional IRA stand. In 20 years, you will have over $83,000 more in your combined accounts (even after factoring in the taxes on your traditional IRA) than you would have had without the conversion.
John Jamieson is the best-selling author of "The Perpetual Wealth System." Follow him on Facebook and Twitter.