We are being hit by a hefty tax bill this year.
One of the biggest reasons is that we EARNED SO MUCH MONEY last year. Nah, just kidding, only in my dream...
The true reason is that we converted all of our traditional IRA accounts into Roth IRA.
We started contributing into traditional IRA accounts several years ago & were feeling pretty good about it. That is until... last year. As the recession's gone deeper & deeper, our account shrank & shrank.
After some denial, anger, bargaining, depression, & acceptance, we decided to take advantage of this disastrous situation. Thus, converting our traditional IRA accounts into Roth IRA accounts.
Why we decided to do this?
Unlike traditional IRA, our money in Roth IRA grows tax-free (we are not taxed on withdrawals (including earnings) from Roth IRA as long as you wait until 59.5 & have had the account for at least five years). Plus, there is no minimum distribution requirement @ the age of 70.5.
We are optimistic that the economy will recover by the time we turn 60. We also do not expect our income tax bracket to decline after we retire (we are pretty much at the bottom right now... & I do plan to get back into workforce in a near future.). So we thought, tax-free withdrawals sound pretty good!!
The downside is that we cannot deduct our Roth IRA contributions. Converting does not come cheap, either. When we convert Traditional IRA into Roth IRA, the conversion is considered as a (penalty-free) withdrawal from Traditional IRA, and would be taxed on the withdrawal.
The good thing (& the main reason why we decided to convert right now) is that taxes are based on the value of our IRA on the day we make the conversion. This means we would be taxed on our pathetically shrank IRA, instead of our initial contributions.
We thought it would work for us, but what works for us may not work for you. We researched and planned hard before taking this action - thankfully, I am a bit of tax code freak (how nerdy is that?).
Some things to consider before converting to a Roth IRA include;
Here is a great calculation site to figure out how much you would save by converting.
* Be sure to pay estimated tax on the withdrawals at the time you convert in order to avoid penalty for underpayment of estimated tax.
A recommended reference article (includes case studies) - "To Convert or Not to Convert, That is the Question" by Robert S. Keebler & Stephen J. Bigge.
I am no financial expert & it is always a good idea to consult your financial advisor before making any big financial decisions.
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