The end of the year is a common time for people to look into rolling over an existing individual retirement account or a 401(k) from a previous employer into a Roth IRA. But you better hurry -- the deadline is Dec. 31 to qualify for the 2016 tax year.
Why would you want to roll over an existing 401(k) or traditional IRA into a Roth IRA? As this Roth IRA calculator shows, the tax advantages can be significant. Unlike other accounts, you pay no taxes on withdrawals in retirement. That's especially attractive if you think you'll be in a higher tax bracket when you retire; by paying taxes now, you don't have to pay later.
There are other advantages to rolling over to a Roth IRA. Once it is in a Roth IRA, the money -- and any additional contributions you make, plus investment earnings -- will be available for tax-free withdrawals when you hit age 59½. Unlike a traditional IRA, there is no minimum Roth withdrawal required at age 70½ -- so if you want to grow the size of your estate for your loved ones, that Roth IRA can be ideal.
Annual Roth IRA contributions are capped at $5,500 (or $6,500 if you are age 50 or over). But there are no limits to the amount you can transfer from another qualified retirement account when doing a Roth conversion. One big caveat: You will have to pay taxes upfront on the conversion.
How to do a Roth conversion
If you don't have an existing Roth IRA, first create an account with an online broker or robo-advisor. For a 401(k) rollover from an existing account, contact your former employer's plan administrator and initiate a "direct rollover" (rather than an indirect rollover, which will require you to move it to the new account yourself within 60 days -- that gets complicated).
Your new Roth IRA provider will give you detailed instructions on the move, what information you'll need -- like the new account numbers -- and where the cash should be sent.
Then begin investing. Unlike many employer-sponsored 401(k) plans, Roth IRA account providers often have a much wider selection of mutual funds, including index funds and exchange-traded funds from which to choose.
Converting to a Roth IRA isn't for everyone, and having the ability to pay the taxes upfront is key. But if it makes sense to pay those taxes now rather than later, this investment product may be right for you.