Converting a traditional IRA to a Roth IRA isn't always a good idea
Author: David Ryska
A Non-Disadvantage?
Before we get into the main disadvantage, let's look at one issue that's sometimes mentioned incorrectly.
Here's one of the key principles of tax planning: other things being equal, it's better to pay taxes later than to pay taxes sooner. For example, if you can delay selling stock at a gain until the following year, you'll delay paying tax on that gain and continue to invest the pre-tax amount, not the after-tax amount. Some people have suggested that converting to a Roth IRA is bad tax planning because it means paying taxes sooner than necessary.
When you move money to a Roth IRA, you have an opportunity to avoid ever paying tax on the future income and gain earned by that money. The sooner you move to a Roth IRA, the greater the amount of earnings that will be tax-free. Other things being equal, the benefit of getting a greater amount of earnings tax-free precisely offsets the detriment of paying taxes sooner. Naturally, if you have a choice between converting in December of one year of January of the next year, there may be an advantage in waiting so you can pay the conversion tax a year later. Overall, though, the fact that conversion requires you to pay tax now rather than when you withdraw money in retirement does not create a detriment, because of the offsetting benefit of completely eliminating tax on earnings in the Roth IRA.
Rate Shifting
A key potential disadvantage of converting a Roth IRA is rate shifting. This means paying conversion tax at a higher rate than you would have paid if you left the money in your traditional IRA and withdrew it later. This is a genuine possibility for many people who are in their prime earning years now and expect to be in a lower tax breaket when they retire. It's also an issue for people who are converting very large IRAs, because of the great likelihood that the conversion income will push them into a higher tax bracket.
The issue is most important for people who are close to retirement. Tax rates change quite frequently, so it's dangerous to predict what they might be more than a few years from now. I'm inclined to discount this issue altogether if you're not planning to use your IRA within the next 20 years. Also, in most cases I would expect the advantages of the Roth IRA to outweigh a small rate shift, such as the difference between the 25% tax bracket and the 28% tax bracket.
Tax payment problems
Apart from the possibility of an unfavorable rate shift, the main indication that a conversion may not be appropriate is a problem in paying the conversion tax. This is especially true if you may have to withdraw IRA money to pay the tax, and be stuck paying the 10% early distribution tax.
Other Distadvatages
Other potential disadvantages of converting to a Roth IRA are difficult to quantify but worth mentioning in case they may be significant to you:
Creditor protection. Initially at least, the laws of some states were unclear as to whether they provide the same level of protection from creditors for a Roth IRA as for traditional IRAs. Check this out if it's a concern.
State taxation. Does you state follow federal law regarding tax treatment of the Roth IRA? As far as we know they all have decided to do so, but you may want to check this out, too.
Flexibility as a disadvantage. One of the advantages of the Roth IRA is that it's easier to lay your hands on the money before age 59.5. This can be a disadvantage if it encourages you to withdraw funds you should have left untouched until retirement.About the Author:
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