Is a Roth IRA Conversion REALLY a Good Idea?
Over the next several months you will hear more and more about converting Traditional IRAs to Roth IRAs. The majority of the articles I have read so far focus on the mechanics of a conversion NOT the issue of whether or not converting is a good idea. There seems to almost be an implicit assumption that converting from a Traditional IRA to a Roth IRA is a good idea.
This spin in the financial press is so pervasive that when our office started an analysis of the conversion issues, we shared this bias in thinking “of course it will be a good idea to convert.” However, upon deeper study, we concluded it’s not so simple. There are a lot of factors to consider, especially for the many people who will need to use their IRA money in retirement, for whom converting to a Roth IRA may very well be a bad idea!
Why is this an issue at all?
On January 1, 2010 the income limitations for converting a Traditional IRA to a Roth IRA will disappear. Until then, many people are prohibited from converting to a Roth IRA because their income is too high. Roth IRAs can be a fantastic planning tool. Investments in both Roth IRAs and Traditional IRAs grow tax deferred. So what’s the difference?
- With most Traditional IRAs, you take a tax deduction for your contribution, the money grows tax deferred, and you pay taxes when you withdraw the money from the IRA.
- With a Roth IRA, there is no tax deduction for contributing money, the money grows tax deferred, and withdrawals are tax free for retirement.
On January 1, 2010, anyone with a Traditional IRA will be able to convert it to a Roth IRA, regardless of their level of income. The tax free withdrawals are what appeal to most people and is the primary reason conversions from Traditional IRAs to Roth IRAs is becoming a very hot topic in the financial press.
The conversion from a Traditional IRA to a Roth IRA is not free or painless. By far the largest consideration is that in order to make the conversion you have to pay income taxes on the money you are converting. This is not a simple decision. Among other things you need to consider:
· How long you have before you need to start taking withdrawals from your IRA.
· The rate of return you can earn on investments both inside and outside the IRA.
· How much you’ll have to pay in taxes to make the conversion.
· What you think tax rates will be in the future, when you need to take withdrawals.
· Whether you have money outside your IRA to pay the conversion taxes, or whether the taxes would have to be paid with money from the IRA itself.
The key point to emphasize is that the decision requires thought and planning. You do not want to make a costly mistake. You should discuss this with both your CPA and your financial planner to be sure you make the right decision.
Sincerely,
Glen Janken, CFP, CLU |
