Does a Roth conversion always make sense?
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 bill
If 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 In addition, if you’re younger than 59½, you’ll pay a 10 percent penalty on the money withdrawn.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 retirement
The 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.
3. You’ll be in a lower tax bracket at retirement
If you keep your money in a traditional IRA, you pay taxes on the money as ordinary income as you withdraw it. So if your tax rate is going to fall upon retirement, you’re generally going to save money by sticking with a regular IRA. And most people outside of the two top brackets historically see their tax rates fall when they retire.
To be sure, the government will almost certainly have to raise taxes to shrink the exploding budget deficit. But if Congress takes no action, tax rates are scheduled to rise for all brackets Jan. 1, 2011. So it’s difficult to predict your future rates with any certainty.
4. You get pushed into a higher tax bracket
Converting to a Roth IRA adds the IRA’s value to your ordinary income in the year that you make the conversion, except for conversions made in 2010. The income created by 2010 conversions can be spread evenly between 2011 and 2012 for tax purposes.
So if you decide to convert a $100,000 traditional IRA to a Roth IRA next year, $100,000 will be added to your ordinary income. That could put you in a higher tax bracket, which may turn the conversion into a losing proposition.
Increasing your income level can have other negative consequences as well. It may eliminate your eligibility for education and other tax credits that have income limits.
For those with children in college, the higher income level can wipe away your chance for financial aid. “From what I’m reading, colleges are including the extra income in their calculations,” says Wiggins. “They aren’t saying, ‘Oh this is just a Roth.'”
5. You’re going to give the IRA to a charity
If you give your IRA to charity, there’s no savings created by a conversion because charities don’t pay income taxes. So they won’t have to pay any taxes if you give a traditional IRA. Also, if you’re planning to give the IRA to heirs who will take the money out right away, resist doing a conversion. An heir who quickly takes money out of a Roth IRA defeats the purpose behind conversion — which is to let the IRA grow for years to compensate for the initial tax payment.
So if you’re thinking of converting to a Roth IRA, make sure it fits your financial situation before taking the leap.