Most articles explore when you should do something or why you should, but not many talk about when you shouldn't. There are many good reasons to do a Roth Conversion but a few reasons why you shouldn't. In this article I'll talk about the two primary reasons not to do one. To get us started, I'll briefly explain what a Roth conversion is and then get into the reasons why you may want to think twice.
A Roth conversion is when you have money in a traditional IRA (or similar retirement account) and you take that money and move it over to a Roth IRA. It's not a difficult transaction to carry out, but it's one you want to get right or there could be adverse consequences, as we will discuss below.
The reason people do a Roth conversion is because they recognize that leaving their money in the traditional IRA means when it grows they will have to pay taxes on every dollar in the account in retirement when they take it out. They are willing to pay tax on the money in the account now to avoid paying taxes on a larger balance in the future. With that high level explanation, let's get into the two key reasons not to convert.
You Don't have the Money to Pay the Tax
When you convert all or a portion of your IRA to Roth you have to pay taxes on the money you take out in the current year. For example if you converted $10,000 and you are in the 22% tax bracket then you are paying $2,200 more tax this year then you would otherwise pay. The reason for this is when you put the money into the traditional IRA you got a tax deduction for it and you haven't paid taxes on any of the money in that account. If money is tight and you can't come up with the extra $2,200 to pay the tax, then you shouldn't do the conversion. You might ask "Can't I just have the custodian withhold the tax from the $10,000 that I convert?" In other words, can I have them put $7,800 into my Roth and send the other $2,200 to the IRS? The answer is you can, but it's generally a bad idea to do this. The reason it's a bad idea is because you didn't move the full $10,000 to the Roth account, the IRS treats it as though you converted $7,800 and you kept the rest for yourself. In that case, if you are under age 59.5 then you have an early distribution. This means that not only do you pay taxes on the $10,000 but you also pay an early withdrawal penalty of 10% on the $2,200. You end up paying a $220 penalty on top of the taxes. That's not really a good result for most of us. How long will it take to make up that 10% penalty in the Roth account? It could be a long time.
You believe your tax rate will be lower in the future
A second reason you may not want to do a Roth conversion is if you are at a high income tax bracket now and you expect to pay less taxes later. Let's assume you have a great job and you are single, you make $200,000 per year and therefore you are in the 32% tax bracket. Next year you will be getting married and your spouse makes $100,000. When you file jointly next year your combined income would be $300,000 and you would be in the 24% tax bracket. If you wait until next year to do a Roth conversion, then you would save 8% in tax by doing your conversion then. Another example could be where you are married making $250,000 combined but you both will retire on December 31 of this year. Next year you expect to live on $70,000 per year because you just paid off your mortgage and you plan to live a simple life. If you did a Roth conversion in the current year you would pay tax at 24% whereas next year you would pay 12%. By waiting 1 year, that $10,000 Roth Conversion would only cost you $1,200 in taxes instead of $2,400. That leaves more money in your pocket. Keep in mind that we often expect to pay less taxes in retirement, but will that really be the case? Discuss potential scenarios with your financial advisor where it may be possible your tax rate is higher in the future. In that case the Roth conversion would make sense.
Disclaimer- The content in this article is not tax, legal or investment advice. It is for educational purposes. Please contact your financial advisor or reach out to us at smoran@redbarnfinancial.com with questions specific to your situation.