3. Set aside some money for taxes if doing a Roth conversion
A Roth conversion shifts money from a traditional IRA into a Roth IRA. The benefit of making this change is that you will change the status of your IRA from tax-deferred to tax exempt. With a traditional IRA, you pay no taxes on your contributions, only on withdrawals. A Roth works the opposite way; you pay taxes up front so you don’t have to pay them when you make withdrawals. A Roth conversion works like a vaccine shot against future tax increases, and now is a good time to make the conversion, when taxes are at historic lows. The problem is that you will need to pay taxes on the full balance of your conversion in the year you make it. So if you’re thinking of performing a Roth conversion, it’s a good idea to set aside some money in advance to pay the taxes on the money you will convert.
Many people use the money in their accounts to pay the tax bill, but this can take a sizeable chunk out of their savings. Since any money converted to a Roth IRA will be counted as income for that year, you will actually end up paying tax on the money you used to pay the taxes on your Roth conversion. You will also most likely be bumping yourself into a higher tax bracket, meaning you will pay a higher rate on the rest of your (non-IRA) income for the year. One more thing to consider: The more money you have in your new Roth IRA, the faster it will grow. So why would you want to take money out of your account to pay your tax bill? If you pay the tax bill with money from your IRA, it could take years to recoup those losses and get back to your original sum.
