Disadvantages of Conversion
There are some drawbacks
By
Kaye A. Thomas
Updated September 25, 2006
Converting a traditional IRA to a Roth IRA isn't always a good
idea.
Many people are excited about the benefits of converting to a Roth IRA. Yet even the
most enthusiastic supporters of Roth IRAs will admit that there are situations where
conversion is not a good idea.
A Non-Disadvantage?
Before we get into the main disadvantages, 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 bracket 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.
| If you're close
to retirement and expect your tax bracket to drop significantly (say, from 25% to 15%),
think twice before converting to a Roth IRA. |
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. We discuss this point separately here:
Source of Funds for Conversion Tax.
Other Disadvantages
Other potential disadvantages of converting to a Roth IRA are difficult to quantify but
worth mentioning in case they may be significant to you:
- State
taxation: Does your 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 59½. This can be a disadvantage if
it encourages you to withdraw funds you should have left untouched until retirement.
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