Vanguard Traditional IRA to Roth IRA Conversion
- IRA accounts:
It's easy to convert a Traditional IRA account into a Roth IRA at Vanguard. However, before making the conversion, think thoroughly whether the conversion makes sense.
I mentioned in my previous post that I have made some changes to how we invest our money this year and one of them was starting to contribute to Roth IRA accounts again, though we don’t qualify to make direct contributions.
The advantage of Roth IRA over Traditional IRA has been discussed extensively, such as tax free withdrawal and no required minimum distributions after the age of 70.5, etc. We have been making non-deductible contributions for years, first to Roth IRA accounts, then to Traditional after we reached the income limit that prohibits us from adding new money into the accounts (you don’t have to know everything before opening an IRA account). Even though there was always the opportunity to do a one-time conversion from Traditional to Roth in the past, we never took that step because our IRA accounts were still relatively small, thus the benefit of the conversion was rather small if we could only keep contributing to Traditional. Then, in 2009 a new law opened the door to convert existing Traditional IRA accounts into Roth regardless the income. Furthermore, it also makes it possible for people like us who are not eligible to make Roth contributions to actually continue funding their Roth accounts through conversion, year after year, until Congress decides to shut that door again.
When the conversion first became available in 2010, I looked into the idea, but decided not to convert for our existing accounts. From what I read about the pros and cons of IRA conversion, the two determining factors are now and future tax rates and source of funds to pay for the taxes resulted from the conversion. Since the Traditional to Roth conversion is considered distribution, which is a taxable event, taxes are due at the time of the conversion for deductible Traditional contributions and for all the earnings from the conversion. The argument was that if one has to use funds from the IRA account to pay for the tax bill, then it doesn’t make too much sense to convert, especially if the IRA is large. For us, since our accounts are quite small and our contributions were all after tax, we will be only responsible for the taxes on the earnings, thus the tax bill isn’t really the biggest concern. My decision was mainly based on the assumption that our marginal tax rates at the time when we retire will be lower than the rates we are taxed right now.
For the tax rates, the comparison seems to be quite simple to make. Currently, our incomes are our wages, which are taxed at much higher rate. Because none of us has pension, the sources of income in our retirement will mostly come from Social Security, if it’s still there, and from savings that we set aside right now, 401(K)s, IRAs, and savings outside tax-deferred retirement accounts. For 401(K)s, since contributions were all made pre-tax, any withdrawal in the future, including both the contributions and gains, will be taxed. For IRAs and other savings, however, only the earnings will be taxed because of after-tax contributions. So looking at our situations, it doesn’t seem to be difficult to come to the conclusion that our tax rate in retirement will most likely be lower than our current income tax rate, even though nothing is certain. Based on this, I chose not to convert our existing Traditional IRA accounts, which also include 401(K)s rolled over after previous jobs, which could result in taxes on earnings and pre-tax contributions to those 401(K) plans at the current tax rate.
However, I still like Roth IRAs more than Traditional IRAs for the 100% tax free withdrawal after 59.5 years old, especially since we are making after tax contributions right now any way. The only problem is to find a way to fund the accounts, which turned out to be quite simple. In the past, I always made small monthly contributions to the IRA accounts throughout the year. But for 2013, I chose to fund the Traditional IRA accounts at once then convert them into Roth immediately before any earnings or gains occur. With both our Traditional and Roth accounts at Vanguard, the process was rather easy. Here is what I did:
- Open new Traditional IRA accounts at Vanguard and fund them to the maximum amount allowed ($5,500 for 2013)
- The Vanguard mutual fund for the new accounts is the Prime Money Market fund, not any other mutual funds
- After a day or two, the new accounts with the new money will be available, then I will do the conversions to Roth, even before the money is settled in the new Traditional accounts.
Converting a Traditional IRA to a Roth, called Exchange, is also straightforward at Vanguard, a few mouse clicks and it is done. To do the conversion after logging into the account, select Buy & Sell from the top of the screen, then click Exchange Vanguard Funds and follow the steps to complete the conversion.
The process is very simple, taking only a few minutes to complete. Of course, the conversion can be done at any time of the year. The reason I chose to convert right after the contributions are made is that by doing so, there’s no earning generated, thus no tax needs to be paid for the conversion.
I plan to do this every year as long as the law is still in place
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