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Think carefully before making any decisions

Quick Summary

  • A Roth IRA conversion lets you turn a traditional IRA into a Roth IRA.
  • There’s no upfront tax-break with a Roth IRA, but contributions and earnings grow tax-free.
  • You’ll owe tax on any amount you convert, and it could be substantial.

Everyone tries to limit the amount of taxes they pay. Taxes, whether we admit it or not, drive a lot of our personal finance decisions. Avoiding or lowering them can influence where we choose to live, what kind of car we buy, where we send our children to school, whether we purchase a house, and many other everyday decisions. Taxes play a large role when we invest for retirement, as well.

One potential way to minimize taxes is by investing in a Roth IRA. With a Roth IRA, you contribute after-tax dollars and withdraw any earnings tax-free in retirement.

By contrast, although you generally get a tax deduction on your contributions to a traditional IRA—and the money grows tax-free—you have to pay taxes when you withdraw the money in retirement. To avoid this, many investors do a Roth IRA conversion, moving their money from a traditional IRA to a Roth.

What is a Roth IRA Conversion?

An IRA conversion is simply changing the account classification from a traditional IRA to a Roth IRA. Beginning in 2010, the federal government began allowing investors to convert their traditional IRAs into Roth IRAs, regardless of the amount of income they earned.

In general, people can invest in a Roth IRA only if their modified adjusted gross income (MAGI) falls below a certain limit. For example, if you’re married filing jointly and earn more than $203,000 a year, you can’t invest in a Roth IRA. That’s still true for annual Roth contributions. But there are no income limits for conversions.

Pros and Cons of a Roth IRA Conversion

Pros of a Roth IRA Conversion

  • Contributions and earnings grow tax-free.
  • You can withdraw contributions at any time, for any reason, tax-free.
  • You don’t have to take RMDs.

Cons of a Roth IRA Conversion

  • You pay tax on the conversion—and it could be substantial.
  • You may not benefit if your tax rate is lower in the future.
  • You must wait five years to take tax-free withdrawals, even if you’re already age 59 1/2.

The Pros of a Roth IRA Conversion

Like most investment decisions, a Roth IRA conversion has its advantages and disadvantages.

A key benefit of doing a Roth IRA conversion is that it can lower your taxes in the future. While there’s no upfront tax break with Roth IRAs, your contributions and earnings grow tax-free. In other words, once you pay taxes on the money that goes into a Roth IRA, you’re done paying taxes, provided you take a qualified distribution.

While it’s impossible to predict what tax rates will be in the future, you can estimate if you’ll be making more money, and therefore, be in a higher bracket. In many cases, you’ll pay less in taxes in the long run with a Roth IRA than you most likely would with the same amount of money in a traditional IRA.

Another perk is that you can withdraw your contributions (not earnings) at any time, for any reason, tax-free. Still, you shouldn’t use your Roth IRA like a bank account. Any money you take out now will never get the opportunity to grow. Even a small withdrawal today can have a big impact on the size of your nest egg in the future.

Moving to a Roth also means you won’t have to take required minimum distributions (RMDs) on your account when you reach age 70 ½. If you don’t need the money, you can keep your money intact and pass it to your heirs.

The Drawbacks of a Roth IRA Conversion

The largest disadvantage of converting to a Roth IRA is the whopping tax bill. If, for example, you have $100,000 in a traditional IRA and convert that amount to a Roth IRA, you would owe $24,000 in taxes (assuming you’re in the 24% tax bracket). Convert enough and it could even push you into a higher tax bracket.

Of course, when you do a Roth IRA conversion, you risk paying that big tax bill now when you might be in a lower tax bracket later. There’s no way to know for sure what tax rates (and your income) will be in the future.

Another drawback: If you’re younger, be careful to keep the funds in your new Roth for five years and make sure you’ve reached age 59 ½ before taking out any money. Otherwise, you’ll be charged not only taxes on any earnings, but also a 10% early withdrawal penalty. There are exceptions so consult a tax advisor first.

Paying the Tax Bill on a Roth IRA Conversion

If you do a Roth IRA conversion, how will you pay that tax bill? And when?

Many people don’t realize they can’t wait until they file their taxes to pay the tax bill on the conversion. You must send in a check as part of your estimated quarterly taxes.

The best way to pay the tax bill is to use money from a different account—such as from your savings or by cashing out a CD when it matures. The least preferred method is to get the money from the retirement investment that you are converting. Here’s why.

Paying your taxes from your investment, instead of from a separate account, will erode your future earning power. Say you convert a $100,000 traditional IRA, for example. After paying taxes, you end up depositing only $76,000 into a Roth IRA. Going forward, you’ll miss out on all of the interest that you would have earned on the money. Forever.

While $24,000 may not seem like a lot, compounding interest means that money could grow to about $112,000 over the course of 20 years all by itself at an interest rate of 8%. That’s a lot of money to forgo in order to pay a tax bill.

Making a Decision

A Roth IRA conversion can be a very powerful tool for your retirement. If your taxes rise because of increases from the government—or because you earn more, putting you in a higher tax bracket—a Roth IRA conversion can save you considerable money in taxes over the long term.

But, there are several drawbacks to a conversion that should be taken into consideration. It’s important to think carefully about whether or not it makes sense to do a conversion and consult with a tax advisor about your specific situation.

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