6 Reasons To Think Twice Before Converting to a Roth IRA
A Roth conversion is the process of rolling over retirement funds invested in a pretax account (like a regular IRA or 401(k)) into an after-tax Roth IRA. It is often promoted as a smart move for retirement planning, as you'll pay capital gains taxes at the time of rollover, but no taxes in retirement when it's time to withdraw from the Roth.
However, before making a move that could permanently alter your retirement taxes, it's important to understand the risks. Here are six times you should not do a Roth conversion, according to finance experts, and why skipping it could protect your long-term retirement plan.
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1. You Expect Your Income To Drop in Retirement
"One of the biggest mistakes people make with Roth conversions is assuming they're always a good idea, according to Stephan Shipe, certified financial planner (CFP), founder and CEO of Scholar Advising. However, he said, "If you're still working and expect your income to drop in retirement, it often makes sense to wait. Paying taxes now at a high rate, when you could defer and pay at a lower rate later, can undermine the strategy entirely."
Shipe said Roth conversions are best timed during low-income years, such as after retirement but before required minimum distributions or Social Security benefits begin.
"That window creates an opportunity to shift assets without pushing into higher tax brackets or triggering IRMAA (Income-Related Monthly Adjustment Amount, for Medicare) surcharges," he said.
Another overlooked point is that tax law isn't fixed, Shipe pointed out. "Roths are appealing because they hedge against future tax increases, but conversions are taxed under today's laws." With the odds of higher tax rates in the future, that hedge only has value if it doesn't strain your cash flow or jeopardize other parts of a financial plan, he explained.
2. It Will Bump You to a Higher Tax Bracket
The retirement account rollover dance can get exhausting, but converting money from a traditional IRA or 401(k) into a Roth IRA means paying taxes upfront in exchange for tax-free withdrawals later. While that trade-off can be powerful in the right situation, it can also backfire if the timing or tax bracket isn't aligned. The last thing you want is to increase your tax bill or reduce cash flow on a fixed income.
If you're close to retirement, you're probably in your highest earning years and facing your highest tax brackets, which is a good reason to think twice about a Roth conversion, according to Carson McLean, founder and lead wealth advisor at Altruist Wealth Management.
"Doing a Roth conversion while in a peak tax bracket means you pay more tax now than you might need to. For most people, it is better to wait until after they retire, when income drops and they fall into a lower bracket," McLean said.
That window between retirement and when required minimum withdrawals (RMDs) or Social Security start is usually the best time to do conversions because you can control your taxable income and minimize the tax bill.
3. You Want To Keep Medicare Premiums Lower
Retirees can begin taking Medicare health insurance at age 65, but be warned: a Roth conversion raises your modified adjusted gross income for the year, McLean said.
"This higher income can push you into a higher Medicare premium bracket, which means you will pay more for Medicare Part B and Part D two years later."
For people who are not yet on Medicare and get health insurance through the ACA marketplace, a higher income can reduce or eliminate their subsidies, leading to much higher out-of-pocket premiums. "These added healthcare costs can quickly outweigh any tax benefits from the Roth conversion," McLean said.
4. You Earn a Low Income
People with low income may not benefit much from a Roth conversion, either, especially if their tax rate will not increase in the future, McLean said.
"The bigger issue is cash flow," he added. "Ideally, you want to pay the conversion tax from money outside your IRA, so you keep more in the account growing tax-free."
If you don't have extra cash, paying the tax from the IRA reduces your retirement savings and the potential benefit of the conversion.
5. You're Leaving an IRA to Charity
If you have charitable inclinations and plan to leave your IRA to a charity, there is no benefit to converting, McLean said.
"The charity does not pay taxes, so the account goes to them tax-free either way. If your heirs will be in lower tax brackets than you are, it is usually better to let them inherit the traditional IRA and take withdrawals over time."
6. You're Converting a Lot of Money at Once
A Roth conversion can also trigger a leap into a higher tax bracket if you try to convert a lot of money at one time, according to Doug Carey, a certified financial analyst at WealthTrace.
"If possible, it is best to spread out the conversions over several years to avoid moving into a different tax bracket," he said.
You should also avoid converting when other income is coming in, such as stock options or a large bonus.
Final Take To GO: Other Conversion Concerns
The bottom line is that everyone's retirement situation is unique, but that doesn't mean you can't follow tried and true financial guidance that will help put your right foot forward. According to Carey, some final considerations for holding off on a conversion because it won't be worth the taxes are:
You are receiving Social Security benefits or will very soon.
You have a pension, which already puts you in a higher tax bracket than those without a pension.
Your life expectancy is low. A Roth conversion takes time to break even because of the large tax liability when the conversion occurs.
You don't have enough taxable income to pay the taxes on the conversion.
The best way to find out if a Roth conversion is right for you is to talk with a fiduciary financial advisor.
Caitlyn Moorhead contributed to the reporting for this article.
This article was provided by MoneyLion.com for informational purposes only and should not be construed as financial, legal or tax advice.