To Convert on not to Convert... That is the question

Converting a traditional IRA to a Roth IRA can be a savvy financial move for some individuals, offering benefits such as tax-free growth and withdrawals in retirement. However, it's not always the right choice for everyone. This article will cover the key pros and cons of a Roth conversion to help you decide if it’s the right strategy for your financial goals.

Pros of Converting a Traditional IRA to a Roth IRA
1. Tax-Free Withdrawals in Retirement
A major advantage of a Roth IRA is that withdrawals in retirement are tax-free, as long as you meet certain requirements (the account must be at least five years old, and you must be over 59½). With a traditional IRA, you’ll owe income tax on withdrawals, which can be a significant drawback if you expect to be in a high tax bracket in retirement.

2. No Required Minimum Distributions (RMDs)
Unlike traditional IRAs, Roth IRAs do not require you to start taking RMDs at age 73. This can be advantageous if you don’t need to access your retirement funds immediately and would prefer to let the funds continue growing tax-free.

3. Lower Tax Rates During Conversion
Converting to a Roth makes the most sense if you expect your tax rate in retirement to be higher than it is now. By paying taxes on your IRA balance today, you can lock in a lower tax rate. This is particularly appealing if you believe tax rates will rise in the future or if you’re currently in a low-income year.

4. Ability to Pass on Wealth Tax-Free
For those focused on estate planning, Roth IRAs offer a benefit: heirs who inherit a Roth IRA can take distributions tax-free (although they must empty the account within 10 years). This makes Roth IRAs a desirable asset for those wishing to pass on tax-free wealth to their beneficiaries.

5. Flexible Withdrawal Rules
Contributions (but not earnings) to a Roth IRA can be withdrawn at any time, for any reason, without taxes or penalties. This flexibility can offer some peace of mind for individuals who might need to access funds before retirement.

Cons of Converting a Traditional IRA to a Roth IRA
1. Immediate Tax Bill
The biggest drawback to converting is the tax liability. When you convert a traditional IRA to a Roth IRA, you must pay income taxes on the converted amount in the year of conversion. Depending on the size of your IRA, this can mean a hefty tax bill, which might be challenging if you don’t have other funds to cover it.

2. Potential for Higher Tax Bracket
A large Roth conversion can push you into a higher tax bracket for the year, potentially costing more than anticipated. Planning smaller, incremental conversions over several years can sometimes mitigate this impact.

3. Loss of Immediate Tax Deduction
Contributions to a traditional IRA reduce your taxable income in the year you contribute, offering immediate tax savings. By converting to a Roth IRA, you forgo this benefit, which may be a drawback if you rely on the deduction to reduce your taxable income each year.

4. Five-Year Rule on Withdrawals
Roth IRAs have a five-year rule that requires converted funds to remain in the account for at least five years (or until age 59½, whichever is later) before they can be withdrawn penalty-free. This rule applies to each conversion, which can be a concern if you need to access the funds soon after converting.

5. Investment Growth Needed to Offset Tax Cost
Converting is a better option if you expect strong growth in your Roth IRA. If the assets don’t grow enough to compensate for the taxes paid on the conversion, the financial benefit may be less than anticipated.

When a Roth Conversion Might Be Beneficial
● Younger Investors: Younger people have a longer investment horizon for tax-free growth, giving their Roth IRA time to appreciate significantly.
● Current Low-Income Year: If you’re in a lower income year or have significant deductions, the tax on a conversion may be lower than in the future.
● Future Tax Rate Increases: If you expect tax rates to increase or if you anticipate being in a higher bracket in retirement, a Roth IRA conversion could save you money in the long term.

When a Roth Conversion Might Not Be Worth It
● High Current Income: If you’re in a high tax bracket now and expect a lower tax bracket in retirement, a Roth conversion may be less appealing.
● Near Retirement: For those close to retirement, the immediate tax bill on a conversion may not make up for the potential tax-free gains.
● Inability to Pay Taxes Out-of-Pocket: If you don’t have funds outside of the IRA to cover the conversion taxes, it might not be worth shrinking your retirement savings to pay the IRS.

Conclusion
A Roth IRA conversion can be a powerful tool for retirement planning, but it’s not universally beneficial. Evaluating your current tax situation, expected future tax rates, and retirement goals can help you determine if the long-term tax-free growth of a Roth IRA aligns with your needs. Consult a financial planner to assess the tax impact and help you decide if a conversion is the right fit for your retirement strategy.

Jeff Long | Sales Director