Hidden Costs of Roth IRA Conversions

Yes, Roth IRAs are pretty great, but they can come with some potentially costly complications.

Money stashed under mattress
(Image credit: Getty Images)

First, let me start off by saying I love Roth IRAs. The younger you are the better Roth IRAs potentially look. The same goes for people who don't need the money and would like to leave it to future generations. There are very few more effective options for transferring wealth.

Roth IRA conversions are a hot topic right now, because many investment accounts may be down this year due to the recent market declines. But like everything in life, there are downsides to every decision, and today we will explore what some of those downsides are. Let's begin by recapping what a Roth IRA is and how it’s different from a traditional IRA.

  • A traditional IRA gives you a tax break at the time of deposit. You don’t pay any taxes on the money you put into a traditional IRA, and your money grows on a tax-deferred basis. However, when the time comes to start withdrawing money in retirement, you pay taxes on every dollar that comes out.
  • A Roth IRA, on the other hand, provides no tax break when you make your deposit into the account. You pay taxes on the money that goes in, but after that your money grows tax-free, and all qualified withdrawals in retirement are completely tax-free, too.

So, to summarize: With a Roth IRA, there is no deduction upfront, but it's tax-free on the back end. A traditional IRA has an upfront tax break (subject to limits) but is taxable on the back end.

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A Dollars-and-Cents Example: A Roth vs. a Traditional IRA

The reason I love Roth IRAs for younger people is that while they are giving up the tax deduction today, the value of that deduction may be nominal, because typically the younger you are the less you earn and therefore the less you pay in taxes. For example, if I was 25 and made $40,000 per year, a traditional IRA contribution of $5,000 might save me $600 in a 12% tax bracket. If I put that money into a Roth IRA instead, while I would lose the $600 tax break today, what I gained down the road could be much greater. After 45 years that $5,000 might have grown to approximately $157,000 (assuming a 9% annual return). I could cash out that entire $157,000 and pay $0 in taxes on it. If that $157,000 were in a traditional IRA and I took all of my money out in a lump sum at age 65, the taxes would most likely be a lot more than $600, regardless of where tax rates might be in the future.

Therefore, a Roth IRA can be a great savings vehicle for young peopel. The same principle goes for retirees who are in a low tax bracket and want to pass along money to heirs.

Roth IRA Conversions: 2 Caveats to Consider

The IRS also allows you to convert existing traditional IRAs to Roth IRAs, provided that you pay income taxes in the year of the conversion. People use this as a planning opportunity to use current low tax rates to shift assets that would otherwise be taxable to their heirs to a tax-free inheritance. While this can be a great planning option for transferring assets, it isn't without issues.

One issue is that you can’t get a do-over. Unlike a few years ago, once you elect to do a Roth conversion, it cannot be undone. So if tax rates fall lower in the future (however unlikely that might seem), or the value of the account that you are converting is lower due to market declines, once you elect to convert, it is permanent.

Another complication to consider: capital gains rates. An often-overlooked issue with a Roth conversion is that the value of the converted assets may affect your capital gains tax rate. The tax rate you pay on capital gains is a function of your taxable income. In 2020 long-term capital gains rates are as low as 0%, depending on your taxable income. Here is the breakdown for rates for 2020:

  • 0% for those with taxable incomes of $0 to $40,000 for single filers (or $0 to $80,000 for joint filers).
  • 15% for those with incomes of $40,001 to $441,450 (or $80,001 to $496,600 for joint filers).
  • 20% for those with taxable incomes of $441,451 or higher (or $496,601 or higher for joint filers).

As you can see, if your income is low enough, you might not pay any taxes on your capital gains, but if you convert a large amount of traditional IRA assets to a Roth IRA in a single tax year, that capital gains tax rate could go from 0% to 20%, which could result in a lot of taxes that you didn't intend to pay. Worse, if you convert enough money, you could even trigger the 3.8% surtax on net investment income, making your capital gains taxed as high as 23.8%, rather than 0%. That is a huge cost that must be factored into your decision to convert a traditional IRA to a Roth IRA. In 2020, this surtax kicks in for single people with modified adjusted gross incomes over $200,000 (or for joint filers over $250,000).

It is important to contact your tax adviser to do a detailed analysis of the tax effect of converting to a Roth IRA before you actually do the conversion. If you are contemplating a Roth IRA conversion and would like help figuring out if it's truly right for you, feel free to reach out and we can help you decide.

Securities offered through Kestra Investment Services, LLC (Kestra IS), member FINRA/SIPC. Investment advisory services offered through Kestra Advisory Services, LLC (Kestra AS), an affiliate of Kestra IS. Reich Asset Management, LLC is not affiliated with Kestra IS or Kestra AS. Neither Kestra IS nor Kestra AS provides legal or tax advice. The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra Investment Services, LLC or Kestra Advisory Services, LLC.

This is for general information only and is not intended to provide specific investment advice or recommendations for any individual. It is suggested that you consult your financial professional, attorney or tax adviser with regard to your individual situation. Comments concerning the past performance are not intended to be forward looking and should not be viewed as an indication of future results.

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

T. Eric Reich, CIMA®, CFP®, CLU®, ChFC®
President and Founder, Reich Asset Management, LLC

T. Eric Reich, President of Reich Asset Management, LLC (opens in new tab), is a Certified Financial Planner™ professional, holds his Certified Investment Management Analyst certification, and holds Chartered Life Underwriter® and Chartered Financial Consultant® designations.