The Pros and Cons of Converting to a Roth IRA

When it comes to retirement planning, one of the biggest choices you’ll face is whether to choose a traditional or a Roth IRA. They each have their own distinct advantages, but the right one for you will depend on your unique circumstances. 

Unhappy with your original choice? The good news is that you can convert a traditional IRA into a Roth. The bad news? It might be too costly to be worth it. Here’s what you need to know.   

Roth IRAs vs. Traditional IRAs

Before going any further, let’s review the basic difference between a traditional and a Roth IRA. Both of these individual retirement funds are tax advantaged to help you grow your nest egg faster than you would in a plain old brokerage account. The major difference is in when you realize the tax savings.

With a traditional IRA, your contributions are not taxed, which means you can deduct all the money you contribute from your income in that tax year. This can lower your taxable income and save you money upfront. The catch? You’ll pay taxes on the money when you take distributions during retirement. Once you start using the money, it will be taxed at your regular rate during retirement.

With a Roth IRA, your contributions are taxed along with the rest of your income each year — but you’ll never pay taxes on it again. The money grows tax-free until you need it at retirement, when you can enjoy tax-free distributions. 

Roth IRAs are obviously appealing to anyone who doesn’t want to worry about taxes in their retirement, but they have a few other advantages as well:

• Ability to withdraw contributions at any time: Because you already paid taxes on this money, you can withdraw the amount of your original contributions at any time without penalty, which can be handy in an emergency — even before the magic age of 59½.
• No required minimum distribution (RMD): While a traditional IRA forces you to start taking distributions by age 72, you can keep growing your money in a Roth IRA for as long as you like — good news for anyone who plans to live a long life!
• Tax-free inheritance for your heirs: If you die with money left in your Roth IRA, your heirs will also enjoy tax-free distributions, which they can take over a five-year period.  

What Is a Roth Conversion?

If you’re thinking to yourself that a Roth IRA sounds pretty great, you’re not alone. Many people want to make the switch from a traditional IRA to a Roth — if not for all, then for at least some of their retirement savings. 

This can be done via a Roth conversion. A Roth conversion transfers funds from your traditional IRA into a Roth. To do this, you’ll need to pay taxes on the money that you convert — taxes that will be charged at your regular income tax rate when your tax bill is due on April 15.

That sticking point can be enough to stop many people in their tracks, especially if they don’t have the cash on hand to pay that big tax bill. But for some, a Roth conversion is a good choice.

Is a Roth Conversion Right for You? 4 Questions to Ask Yourself

1. Will Your Future Tax Bracket Be Higher Than Your Current One?

This is the hardest question to answer, but getting it right is key. If you will be in a higher tax bracket when you retire than you were when you contributed to your IRA, a Roth IRA will save you money. But how can you know?

This takes careful planning, with research about your projected income over your lifetime and some honest answers about your potential for career growth. Most people earn more at the end of their careers than they do in the beginning, but how much will you need or want during your retirement? If your home is paid off and your children launched, you may be able to live nicely on less. But that means that a Roth IRA won’t save you any money at all, because you’ll have paid taxes at a higher rate back when you earned the money.

The other big unknown is the state of the tax code. Do you think taxes will go up in the future? If so, a Roth conversion can help you take advantage of today’s lower rates.  

2. Can You Afford the Conversion Taxes Today?

Remember, you will owe income taxes on the full amount of money you convert into a Roth IRA in the year you make the conversion. So if you’d like to convert $50,000, can you pay 22% of that in taxes — or even more, depending on your tax bracket? That can be a big chunk of change, and you’ll need it in liquid assets that you can tap into from another account. 

3. Do You Want to Pay the Taxes?

If your finances allow you to pay the taxes, think again: do you want to? What are your goals for opening a Roth IRA? If you have extra money lying around and aren’t worried about paying it to Uncle Sam, great. If you have debt, or are less certain about your future, converting to a Roth could be a gamble that’s not worth it. Even if you’re secure, you may find that traveling, charitable work, or even spending the money on your family now instead of building an inheritance vehicle feel like better uses of the money. Explore your feelings about the money as you work to crunch the numbers.

4. How Long Until You Need the Money for Retirement?

Roth rules require you to hold the account for five years until you make penalty-free withdrawals of the earnings, so plan carefully. Will you need this money before that period is up, or do you have time? If you plan to use the money right away, a conversion isn’t your best move. 

Still uncertain about whether converting to a Roth IRA is a good move? We’re here to help! We’ll walk you through your options, help you calculate your tax burden, and figure out how to structure a conversion if the numbers are in your favor. We can structure a partial conversion or spread it out over time to ensure that you can afford the taxes and don’t accidentally push yourself into a higher income bracket by mistake. Roth conversions are complex, so contact us today for expert guidance.