Pros and Cons: Roth IRA Conversion
Converting your traditional IRA to a Roth IRA allows you to turn tax-deferred savings into tax-free income in retirement. But is it right for you? Here is a more detailed look at the pros and cons.
Potential Pros of a Roth Conversion
Tax-free growth - Once in the Roth IRA, your investments grow tax-free rather than tax-deferred. The traditional IRA just prolongs paying tax on the growth (deferred) until you take it out.
Tax-free withdrawals - Qualified Roth withdrawals in retirement are completely tax-free. To paint a better picture, let’s assume you’re are married filing jointly and you’re over 59.5 with no social security or other income, and you have $250,000 in a retirement account. If it’s in a Roth account, you could make a qualified withdrawal of the entire amount and pay $0 in taxes. If it’s in a traditional IRA you’re probably paying around $40,000 in federal income tax. While it’s unlikely that you withdrawal all at once, you can see the dramatic diffence in taxes.
No required minimum distributions (RMDs) - Traditional IRAs force you to take RMDs after age 72 whether you need the money or not. There are no RMDs for a Roth IRA allowing lifelong tax-free growth. (note these rules do not apply to an inherited Roth IRA)
Tax diversification - Mixing pre-tax and post-tax savings gives you more control in retirement. You can optimize withdrawals each year for your tax situation. I don’t typically recommend someone convert their entire account. It’s usually portions of it and it’s to fill up income in a lower tax bracket and also managing IRMMA surcharges for Medicare.
Tax-free inheritance - Your heirs can inherit your Roth IRA tax-free, allowing them decades of additional tax-free growth.
Access to Contributions - You can withdrawa your Roth contributions at any point. The earnings may or may not be taxable depending on your age (59.5+) and how long it’s been since your first contribution (at least 5 calendar years).
Lower Income year - If you’ve had a change in income and it’s lower than what it has typically been or will be going forward, it’s a great time to see if a Roth conversion is right for you. It allows you to pay tax based on a lower amount earned that you expected going forward.
Possible Higher Future Tax Rates - If you think taxes are going to be higher in the future, then paying some now at a lower rate may be a good move.
No Income Limits - Unlike normal Roth IRA contributions, there are no income limits for you to do a conversion (note there are also no income limits for you to contribute to your 401(k) or 403(b) if they have a Roth option).
Potential Cons of a Roth Conversion
Paying conversion taxes - You must pay income tax on any pre-tax dollars converted to a Roth IRA. And you need to have the tax money sitting outside of your retirement accounts to pay for it. If you’re under 59.5 this is even more important because you’ll get hit with a 10% penalty if you pay the taxes from your traditional IRA as it would be considered an early withdrawal.
Possible lower future tax rates - If tax rates decrease in the future, the paid conversion tax may have been more than if you withdrew it later at a lower tax rate. But this is unpredictable and most people expect to pay more taxes in the future.
“Loss” of tax deductions - Any traditional IRA deductions you claimed in the past will be "paid back" with the conversion taxes. Essentially you got a deduction before and now you’re going to go ahead and pay the taxes now vs later.
5 year waiting period - To access Roth earnings tax-free, you must have your Roth IRA account for at least 5 years and be age 59.5
No Undoing It - For a while, you could undo a Roth conversion if you had a higher income year than expected, but those days are gone. So when you do it, you’re committing to it!
As you can see, Roth conversions involve a tradeoff between paying taxes now for tax-free income later. It’s good to discuss this with your financial planner who will look at your lifetime tax bill estimate vs just trying to lower it today. If you’d like to see if a Roth conversion is right for you, feel free to set up some time by clicking the schedule appointment button on the right!