Five Reasons Not To Convert to a Roth IRA
In a conversion, you take money out of a traditional pre-tax IRA, pay ordinary federal and state income taxes on it, and then move it into a Roth, where it grows tax free. Conversions have been around since 1998, but until 2010, only taxpayers with modified adjusted gross income of $100,000 or less were eligible to do them. The change has opened up conversions to many high income taxpayers who could benefit from Roths and sparked wide interest in Roth conversions.
But conversion isn’t right for everyone earning more than $100,000, any more than it is right for everyone earning less than $100,000. So who shouldn’t convert? In real life, individuals generally have some characteristics, which may make them good conversion candidates and some which may make them poor candidates. Before you convert, it’s wise to have a professional perform a comprehensive analysis of your assets, income, cash-flow needs and estate-planning goals and then to crunch some numbers. But before you consult an expert, it pays to understand the reasons why a conversion may or may not be right for you. The following is a list of five reasons not to convert to a Roth IRA:
- You will be in a much lower tax bracket in the future. If your combined federal and state income tax rate will be 10% or more lower in the future, there are almost no circumstances in which conversion makes sense now. That’s a big drop in rate, but it’s quite possible, particularly if you fall out of the top brackets in retirement and federal tax rates go up only for those at the top, as has been proposed. Or maybe you plan to move from a high tax state (like New York, New Jersey, or California) to one without a state income tax (like Florida, Texas or Nevada). After you move, you can take a fresh look at a conversion, assuming it is still allowed.
- You’re nearing retirement and will spend your IRA. If your tax rate will be the same in retirement as it is now, then a key consideration is whether and when in retirement you’ll need to spend your IRA funds. A major advantage of a Roth IRA is that you don’t have to start taking “required minimum distributions” from it once you turn 70 1/2 as you do from a traditional IRA. As a result, you can leave the Roth money growing tax free for your heirs, who can then spread out withdrawals over their own expected life times. But if you are nearing or in retirement and you’ll need to soon start withdrawing the funds from your IRA for your own living expenses, a conversion probably doesn’t make sense.
- You don’t have non-IRA funds to pay the conversion tax. If you’ve got decades to go until retirement, a conversion might make sense, even if you will need to spend all your funds in retirement. (That’s assuming, of course, your tax rate in retirement won’t be a lot lower.) But there’s another big hurdle: If you have to dip into the IRA itself to pay the tax on the conversion, then you probably should not convert.
- You plan to leave a substantial amount to charity at your death. As a general rule, anyone with large charitable intentions who is over the age of 75 should skip a Roth conversion–unless he or she is in extremely good health. This is because the most tax-efficient asset to leave to charity at death is usually a traditional IRA. The charity does not pay income tax, and the charitable bequest is excluded from your taxable estate. While there may be exceptions to this general rule (say for those who wish to convert so they can leave a tax- free Roth to their grandchildren) the majority of older taxpayers with substantial charitable intentions will fall under this rule.
- You need asset protection. When you retire or leave a job, you can roll your pre-tax retirement savings from a 401(k) into an IRA and then convert to a Roth IRA. But in some states, 401(k)s and other “ERISA Qualified Plans” such as traditional employer pensions, money purchase plans and SEPs, enjoy more protection from creditors than money in an IRA. If you are a retired engineer, a physician, or other individual with a risk of being sued, or if you currently have creditor issues, don’t convert until you have consulted a lawyer who is an expert in asset protection laws. If you plan to move to another state, find out about that state’s laws too.
