Back in 2006, then President Bush signed a $70 billion tax cut provision that changed the eligibility rules for Roth IRA conversions. Starting in 2010, taxpayers with a modified adjusted gross income in excess of $100,000 can now convert a Traditional IRA into a Roth IRA. The easing of the income limit provided individuals planning for retirement with more freedom. But as we'll soon demonstrate, there are some significant disadvantages of Roth conversions too.
In this article, we're going to talk about the downside of Roth conversions. As part of that discussion, we'll first remind everyone why conversions are so popular. Next, we'll list some of the more important drawbacks to a Roth conversion and why converting is not always a good move for investors. Finally, we'll provide a short list of things to consider before converting a Traditional IRA to a Roth IRA.
The Roth IRA is one of the most valuable investment options available to retirement planners today. While Traditional IRAs can offer tax deductions on contributions, the Roth IRA has some key advantages:
Retirement planners wishing to take advantage of the benefits of a Roth IRA often have the option of converting their Traditional IRA, but as mentioned at the start of this article, there are some significant disadvantages to Roth conversions too.
While it's easy to understand the benefits of a Roth IRA, it's easy to understand the downside of conversions too. There are many variations of the same theme that we'll talk about, but the primary problem with a conversion is income taxes. Converting Traditional IRA funds to a Roth IRA trades the tax deferred benefit of the Traditional IRA for the tax-free benefit of Roth withdrawals. Unfortunately, that tax-free benefit comes at a cost: the payment of income taxes in the near term.
When structuring Roth IRAs, policymakers allowed the holders of these retirement plans to withdraw all monies from that account on a tax-free basis, with the understanding that all money placed into a Roth account would be taxable income. This means that all growth of the account occurs on a tax-free basis, as long as all the money placed in the account is on an after-tax basis. This simple rule applies to conversions as well as contributions.
For contributions, this disadvantage is relatively painless because no tax liability is created. Excess income can be directed to a Roth IRA account and the contribution is not tax deductible. Conversions, on the other hand, can be burdensome. Money in the Traditional IRA that has not been taxed (growth in the account plus tax-deductible contributions) will be taxed when converted.
The entire conversion process creates several categories of disadvantages including:
Finally, we'll provide a short list of factors to consider before converting. Even after thoughtful research, it's always a good idea to seek the help of a qualified tax professional. Roth conversions can result in a significant amount of taxes due to the federal government. Talking to a tax professional prior to a conversion can avoid a recharacterization of the IRA later on.
With that warning in mind, here are some key considerations before converting a Traditional IRA to a Roth IRA:
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