No, not religions, although after the holidays spent with warring family factions, some people do question their faith.
Last week, I explained the basics of Roth conversions. For a little more detail, here are some pros and cons making this transaction.
Pros
- Tax Free Withdrawals in Retirement: The big news when Roth IRAs were invented way back in the 1990s is that qualified withdrawals in retirement are tax-free. By converting a traditional IRA to a Roth, you’re essentially prepaying taxes on the converted amount. If you anticipate being in a higher tax bracket in retirement or if you believe that tax rates will increase in the future, a conversion is a good move.
- No Required Minimum Distributions: Roth IRAs are not subject to required minimum distributions (RMDs) during the account holder’s lifetime. Unlike traditional IRAs, where the IRS mandates that you start taking distributions after reaching a certain age. By converting to a Roth, you maintain control over when and how much you withdraw from your retirement savings, providing flexibility in managing your income during retirement.
- Benefits to your heirs: Roth IRAs offer advantages in estate planning. Since there are no RMDs, you can leave the Roth IRA to your heirs, and they can continue to enjoy tax-free growth for up to 10 years after your death.
If all goes well, you will die in your 80s or 90s, just when your kids are in their highest earning years. Inheriting a tax-deferred account will cause big taxes for the 10 years after your death. The Roth IRA, although it still has withdrawal requirements, is tax-free income to your heirs.
Cons
- It will cost you some taxes: When you convert from a traditional IRA to a Roth, you must pay taxes on the converted amount as ordinary income in the year of the conversion. This can be a substantial financial commitment and may push you into a higher tax bracket for that specific tax year.
- Betting on Future Tax Laws Can be a Losing Proposition: Predicting future tax rates is about as accurate as predicting the stock market or greyhound racing. Tax structure will change before your retirement, after your retirement, and even after your death. This makes determining the future benefits of your conversion nearly impossible.
If tax rates don’t increase significantly or if your income drops in retirement, the upfront taxes paid during the conversion may not provide the expected benefits. You are making a bet that your tax situation will be more advantageous in the future, and if that doesn’t pan out, the conversion might not be as beneficial as anticipated.
That being said, I never met a retiree who regretted having a tax-free pool of money to draw down in retirement.
- Reduction in current income: Using funds from your investment pool to pay the taxes on a Roth conversion means you have less money invested for future growth. Ask your financial advisor to run the numbers comparing the short-term reduction in your investment portfolio against the potential long-term benefits of tax-free withdrawals.
Deciding to convert to a Roth IRA takes more than reading an article in Money magazine or watching a Dave Ramsey rant. It’s not for everyone and I always recommend consulting with a financial advisor and your CPA.
