There was a time when all you heard about was a Roth IRA and how it was the new panacea to retirement savings…ahead of traditional IRAs. There was even the ability to convert traditional IRAs to Roth IRAs as an added incentive to make the move. But is it the right move…not for everyone.
Congress first allowed anyone who owned an IRA to make full or partial conversions to Roth IRAs back in 2010. Since then, says The Wall Street Journal in the article “When to Ignore the Crowd and Shun a Roth IRA,” Americans have moved more than $75 billion into these accounts. There are definite benefits, so it’s not surprising that this is such a popular move. However, it’s not for everyone.
It is important to first understand some of the details between traditional and Roth IRAs before you make any decisions on which way you want to go with your retirement savings. Retirement funds that go into a Roth get tax-free growth and tax-free withdrawals, minus any required payouts based on age, which is a sticking point for IRA owners. This was the primary attraction…you can withdraw from your Roth and not pay any taxes at time of withdrawal.
On the other hand, a traditional IRA grows tax free, but withdrawals are taxed as ordinary income. Those pesky Required Minimum Distributions (RMDs) are also a permanent fixture, even if you don’t need the money. So if you wanted to get the maximum tax benefit then many were using a traditional IRA and paying the tax at a lower rate when they withdrew the funds.
There was the ability to convert a traditional IRA into a Roth IRA…is this the right answer? It depends…Roth conversions come at a cost. You’ll have to pay a tax to transfer your money from the traditional IRA to the Roth and you may lose valuable tax deferral, without gaining more valuable tax-free benefits. This is significant and definitely something to consider before doing a transfer.
One thing to keep in mind is that there is a deadline for this conversion. After the tax year 2018, you won’t be allowed to undo a Roth conversion. This means you need to make a decision of which is best for you now and estimate what your retirement situation will look like as well.
There are several reasons you might want to take a pass on the Roth IRA conversion train. Evaluate your own circumstances and see if this makes sense with your given situation. If you need assistance, definitely meet with your estate planning attorney and/or your financial advisor to see how this could impact you today and tomorrow.
One big reason you might not want to do the Roth IRA conversion is if your tax rate is most likely to go down during retirement. If your tax rate is going to be lower when you take withdrawals, the transfer will cost more. If you are going to convert, do so in a low tax-rate year when income takes a dive. For instance, if you are in your 20s and have an IRA and return to school, or if you’ve retired but aren’t yet taking IRA RMDs.
The same analysis goes for someone who is about to move to a state where taxes are lower. If you feel your taxes are going to go down for this year then the conversion might make more sense at that time. But regardless of whether you do it in a low tax year or a higher one, you still have to come up with the money to pay the taxes today.
Where is the money coming from to pay the tax bill for the conversion? If you don’t have the money to pay the tax bill and plan on using money from the IRA to pay it, you’re using assets that could otherwise grow tax free. It doesn’t make much sense to use tax free money to pay the taxes on your IRA.
Converting to a Roth IRA raises your income level for that year. Therefore, benefits that exist at a lower income tax level might lose value as your income takes a leap. Tax breaks for college or other deductions could be lost.
If you make frequent donations to charity, you can use your traditional IRA’s RMD to donate to charity. The donation can count toward your required payout, up to $100,000 per year from your IRA. This can be a significant advantage of a traditional IRA if you make these donations since you don’t get this advantage with a Roth.
As you can see, there are definitely some nuances that go with these conversions and it is important to understand the impacts this can have on you today and tomorrow. Definitely speak with your estate planning attorney about how your IRA works within your estate plan before making any changes. It may not make sense for you to follow the crowd that is doing this when it comes to Roth conversions.