Roth IRA Conversions – Not Always an Easy Decision

 

(As with any tax related topic, PLEASE make sure you fully understand your particular situation.  The descriptions below are general in nature and additional conditions may apply!  Please consider this educational, not specific advice for you to follow!)

 

Converting a traditional IRA to a Roth IRA has become an increasingly popular tax-savings technique.  Nearly $65 BILLION dollars in Roth IRA conversions were completed in 2010 alone (per the latest IRS numbers I could find).  That’s a lot of conversions!

If that many people are converting, it must be a good thing for me, too, right?  Maybe….or maybe not.

For many, many people, a Roth IRA conversion is a great opportunity to pay a little tax now to save a lot of taxes later!  Before you jump at the chance to do one, let’s take a look at what they are – and more importantly – if they’re right for you.

 

What is a Roth IRA Conversion?

With a traditional IRA, contributions are usually tax deductible and the investments grow tax-deferred.  This means you don’t pay tax on the increase in value as it occurs.  Instead, you will pay the tax on the money that is eventually withdrawn from the IRA.

With a Roth IRA, contributions are NOT deductible, but the eventual withdrawals are completely tax-free, including the earnings for most account holders!  Tax-deferred is nice…..tax-free is better!

Congress has created a means by which an existing traditional IRA can be converted to a Roth IRA.  The catch (and, of course, there is one): the amount converted must be claimed as income on your tax return in the year of the conversion.  While no one likes to pay more taxes now, this really makes perfect sense.  Typically, the money in a traditional IRA was contributed PRE-tax, while the money contributed to a Roth IRA is POST-tax.  By claiming the conversion amount as income, you are switching the PRE-tax money to POST-tax money.

So why would you want to pay more tax now?  By doing so, all of the future growth in the Roth IRA is tax-free!  Plus, if you die before using all of the funds in your Roth IRA, your heirs can withdraw the money tax-free, too.

 

Is converting to a Roth IRA always a good idea?

Unfortunately, it seems when you’re dealing with tax law that there are very few blanket rules that apply to everyone and every situation!  Sure enough, Roth IRA conversions are another area where it’s not always appropriate for everyone.   When would it have been better NOT to convert?  Here are a few situations where that may apply:

  • If you have to use money out of the IRA to pay the tax, it may be better to not convert. In my opinion, you should only convert if you can pay the tax due with other money you have saved.  In other words, if you have to take money out of the IRA in order to pay the tax to convert it, you’ve lost the benefit of the conversion!  You’ll have less money left in the IRA and would have been better off leaving it as a Traditional IRA to maximize the compounding.
  • If your tax rat­­­­­­e is lower in retirement, you would have been better off waiting to pay the tax.
  • If the conversion will push you into a higher tax bracket, it might not be the best thing to do! Be sure to consider, too, not just your marginal tax rate, but also the impact of the increased income on other deductions and tax credits!  (Sneak preview: an upcoming post will discuss this very point with more detail!  Be sure to check it out!)
  • If you plan on leaving the IRA to a charity, don’t convert it! The charity doesn’t pay income tax, so there is no benefit for you or them if you do a conversion.
  • If the US switches from an income-based tax system, you may have paid unnecessary taxes. An example of an alternative system would be a national sales tax.  I don’t foresee this happening in our current political environment, but it is possible in a future generation.

 

Roth Recharacterizations – A Rare “Do-Over” Opportunity

Keep in mind, too, that a Roth conversion can be reversed if done so in a timely manner.  This is called a Roth IRA Recharacterization, and more information can be found here.

You can recharacterize for a tax year through October 15 of the next year, even if you already filed your tax return.  This can be a great option if the value of the investments converted to a Roth suffers a drop in value after the conversion.

For example, imagine converting a traditional IRA valued at $25,000 to a Roth IRA in January 2016.  You would need to pay income tax on this amount when you file your 2016 return by April 15, 2017.  Now imagine that by the summer of 2017, the value of the converted Roth IRA is only $15,000 due to a market correction.  In this scenario, you would have paid tax on $25,000 for an investment worth only $15,000!  If you recharacterize the conversion – thus returning the Roth IRA account to a traditional IRA – you would not have to include the $25,000 in your 2016 income.  After a waiting period, you can reconvert the $15,000 traditional IRA to a Roth IRA and only need to claim $15,000 as income in 2017 (instead of the original $25,000 in 2016).

These can get a little complicated, so be sure to check with your financial advisor.

 

Have you considered or completed a Roth IRA conversion?  What were your experiences?

 

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