Many of us are under the impression that it’s best to wait until we are older and in a lower tax-bracket before withdrawing funds from a traditional IRA.
Most of us do that when we reach 72 and are required to start taking Required Minimum Distributions.
But for some, starting to withdraw earlier, and putting that money into a Roth IRA, may make more sense, even for those in high income tax brackets.
The reason for that is that your profits in a traditional IRA are taxed the same way as the money you invested in your account. So if you have $100,000 invested in your IRA and that investment grew by $20,000, you will be paying regular income tax for every dollar you take out of the $120,000.
The reason for that is you received an income tax deduction when you invested your funds into a traditional IRA. So when you withdraw that money, you will be taxed on the income as well as whatever profit you had made.
However, you are not taxed on the profits you make from a Roth IRA account. Of course you don’t get a tax break when you invest in a Roth IRA.
Let’s say you moved your original $100,000 IRA into a Roth IRA. If you earned $20,000 on that income, you would not pay any taxes when you take out the $120,000.
A recent article in the WSJ – written by Glenn Ruffenach – opened my eyes to this strategy. You can’t access the column without having a digital subscription, but I can share the basics from that article and from other sources of information I have read.
Ruffenach doesn’t recommend taking all your funds out of an IRA at once, rather he suggests you do it a little at a time to reduce the possibility of pushing you into a higher tax bracket.
He also suggest that, if possible, you pay taxes on the IRA withdrawal from your savings. Otherwise, he notes, you will be reducing your tax advantage by having the tax withholding taken from your IRA account.
There is no limit on how much of your IRA you can switch into your Roth IRA account.
But there are rules about how much and how quickly you can move your funds out of the Roth IRA.
You can take all your contributions to the Roth IRA any time. However, under some circumstances, you will pay a penalty if you don’t keep your profits in the account for at least five years.
“At age 59½, you can withdraw both contributions and earnings with no penalty, provided your Roth IRA has been open for at least five tax years.” explains Investopedia.
“In sum, if you take distributions from your Roth IRA earnings before meeting the five-year rule and before age 59½, be prepared to pay income taxes and a 10% penalty on your earnings.”
