1997 was the year Senator William V. Roth, Jr. made the Roth IRA. With the Roth, contributions are made with after tax assets, making all your IRA transactions having no tax impact, with withdrawals completely tax free. This differs greatly to traditional IRA’s where contributions are often tax deductible. Meaning, before your contributions are made to your IRA, a tax deduction is made. Now, thanks to new rules, every American is free to convert their IRA’s to a Roth IRA.
The conversion however, will be taxed so the first thing you need to do is find a way to pay the associated taxes. Lucky for those who converted last 2010, because there was a provision where taxes could be payed in 2 gives. But now, this option is no longer available. Converting to Roth is the best thing for your IRA, so how can you pay the taxes? Here are some options:
1. Use IRA Assets
You can simply use the assets that you have within your IRA to pay for the conversion if you don’t have anything else you can use. However, there will be a 10 percent deduction of the IRA money you used because of an early withdrawal penalty. It will also be difficult to regain the money that you withdrew and this can severely cut the potential growth of your IRA. Use your own IRA assets only if there really are no other options for you.
2. Use other available assets
If you have moneys stowed away in a savings account or a CD, you can simply use these to pay for your conversion. This will keep your IRA account intact and with greater potential for growth. Be careful about what money you use though because you might have this saved up for other financial goals. When using an emergency fund, keep in mind that you will need to replenish this fund quickly just in case a real emergency comes up. Also you may choose to use half of your current assets, while also taking half from your IRA account.
3. Use life insurance
This strategy is only for those who plan to use their IRAs for their beneficiaries and not for their retirement. What you can do is purchase a life insurance plan, and upon death of the IRA owner, the beneficiary can then convert the IRA to a Roth while using the life insurance proceeds to fund the tax payment.
Converting to Roth can mean large savings on tax with every contribution. But this also means having to come up with ways to pay for the conversion itself. However you choose to do it, the conversion will be worthwhile because of the future tax savings.