The idea of converting a traditional IRA to a Roth IRA has generated a lot of buzz this year, as income limits were removed from conversions Jan. 1.
But for many -- if not most -- people, converting doesn't make sense, financial advisers say.
"All the talk is that it's great," says Maury Golbert, a partner at accounting firm Berdon LLP in New York City. "And it can be good for certain people who have the right makeup, but it's certainly not a cookie-cutter strategy that applies to everyone."
The issue is that when you make the conversion, the entire value of the IRA is considered ordinary income and thus subject to tax. This immediate tax burden makes the conversion disadvantageous for many. With regular IRAs, you aren't taxed until you take money out.
Here are five situations that would dictate against doing a Roth conversion:
1. You can't pay the tax billIf you don't have enough money to pay the tax bill created by the conversion without dipping into the IRA itself, resist the urge to convert. This is virtually an automatic deal breaker, advisers say.
"The first thing to consider is whether you have the cash to pay for the conversion," says Joe Velkos, a tax specialist at financial advisers HPM Partners in Cleveland. "If you don't, you're making a case against conversion."
Any money you withdraw from an IRA to pay your taxes is money that won't be compounding on a tax-advantaged basis. And the only benefit of an IRA is tax-advantaged compounding for your retirement. In addition, if you're younger than 59½, you'll pay a 10 percent penalty on the money withdrawn.
2. You're close to retirementThe return you earn in a Roth IRA before withdrawing the money should compensate you for the money you lost when you paid the taxes for conversion. But if you're going to withdraw the money soon, you won't have time to rack up large returns.
Advisers say you generally need to hold the Roth IRA for 15 to 20 years to make it pay off. So they generally don't recommend conversion for anyone over age 60.
"If you're going to hold the IRA for less than 10 years, you definitely don't want to do it," says Tom Wiggins, a Certified Financial Planner at Rehmann, a business consulting and financial advising firm in Farmington Hills, Mich.
Assuming an annual investment return of 6 percent, it would take someone in the top tax bracket 18 years to break even on the conversion, estimates Richard Rampell, chief executive of Rampell & Rampell accounting firm in Palm Beach, Fla.
Converting just before retirement isn't a good idea.