6 Reasons You Should NOT Do a Roth Conversion
Roth IRAs come with some great tax advantages, but converting a traditional IRA to a Roth doesn’t make sense for everyone.
With the end of 2020 approaching, many people will turn their sights toward year-end tax planning. A hot topic for high-income individuals and couples is whether to convert a traditional individual retirement account (IRA) into a Roth IRA. While there is no shortage of guidance available from financial advisers and accountants to help identify where a Roth IRA conversion makes sense, there are also plenty of scenarios where it doesn’t.
A benefit of a Roth conversion is that it can allow you to pay taxes on traditional IRA assets now instead of later if you expect to be subject to a higher marginal tax rate down the road. By paying the income tax now, your contributions and earnings grow tax-free into the future inside the Roth IRA.
Another benefit is that you can withdraw your contributions — but not the earnings — from the account at any time (provided you have met the five-year rule discussed below). Also, moving to a Roth IRA also means you won’t have to take required minimum distributions (RMDs) on your account when you reach age 72. (Other than your spouse, your heirs will most likely have to take RMDs on a Roth IRA they inherit from you, but they won’t have to pay taxes on them.)
But for plenty of people, this strategy doesn’t make sense and therefore is ill-advised. If you are considering this strategy, please consider these six scenarios before making your decision:
No. 1: If You Will Be in a Lower Tax Bracket in Future Years
While this point seems obvious, many people often forget to consider the impact of their state taxes. For example, a single person who now lives in New Jersey pays 6.37% on an income between $75,000 and $500,000. But if you’re a Garden State resident and plan to retire soon to Florida — which doesn’t have a state income tax — a Roth conversation may not make sense.
This guideline applies to people outside of the Northeast, too. For example, any residents under age 62 in Georgia should think twice about a Roth conversion. Georgia has a retiree income exclusion starting at age 62 that gets even more attractive each year and hits a maximum of $65,000 per year per person at age 65 and older. It might be worth waiting until you get there.
Next, even if you think tax rates will be higher in the future, consider whether you personally will be in a higher tax bracket. Many people are in a lower tax bracket in retirement than during their working years. Thus, if you are still employed, it might not be wise to convert your traditional IRA to a Roth IRA just yet.
No. 2: If You Don’t Have Enough Cash or Savings to Pay the Conversion Tax
By converting to a Roth IRA, a person is paying tax on their IRA now instead of later in retirement. You shouldn’t plan to use funds from the traditional IRA to pay the tax since your new Roth IRA will have much less money. So, where will that money come from?
For example, assume you plan to convert a $100,000 traditional IRA to Roth and are in the 24% tax bracket. The $24,000 in taxes need to be paid now.
If $24,000 is withdrawn from a savings account to the pay the tax, your new Roth IRA will start with the same $100,000 it had before and will require no more taxes to be paid on distributions in the future. But if you pay the tax from the IRA funds being converted, your new Roth IRA will start with a balance of $76,000 — effectively handicapping it from the very beginning. Moreover, since money withheld from the conversion for taxes counts as an IRA distribution, if you are under age 59½ you will owe a 10% penalty in addition to the income taxes.
No. 3: If You Might Need the Money Within Five Years or Less
Roth conversions involve a couple of “five-year rules” that can generate taxes or penalties if you’re not careful.
- Penalties from early Roth conversions. For anyone under the age of 59½, a five-year “clock” starts on Jan. 1 in the year funds are converted to a Roth IRA. If you take a distribution from the new Roth IRA within this five-year window, a 10% early withdrawal penalty is charged on the principal (we’re not talking about earnings yet). It’s important to note that each Roth conversion you make has its own five-year clock.
- Tax-free distributions of Roth earnings. In order for the earnings from the Roth IRA to be distributed tax-free — not the principal amount originally converted — five years must have passed since your first Roth IRA account is established. Even if you have multiple Roth IRAs opened in different years, this five-year clock starts on Jan. 1 of the year that you opened your first Roth IRA (whether by contribution or conversion). In addition, you must be age 59½ to avoid a 10% early withdrawal penalty.
No. 4: If You Plan to Leave Your IRA to a Charity
Part of the appeal of a Roth IRA is that its assets grow tax-free. However, nonprofit organizations are typically exempt from paying taxes on the distribution of funds from any IRA, whether it’s a Roth or a traditional IRA. Because a charity receiving these assets will not pay taxes for selling the assets and withdrawing them, prepaying taxes by converting to a Roth IRA effectively means the charity will get less funds at your death.
No. 5: If Your Beneficiary Will Have a Lower Tax Bracket Than Yours
If your IRA is large enough that it will likely be left to someone else at your death, it’s important to consider your beneficiary’s tax situation. Deciding whether to convert or not may come down to which account owner, you or your beneficiary, is likely to be in a lower marginal tax bracket. If the ultimate goal is to maximize the value of the account across generations, and taxes have to be paid from the account at some point, it makes sense to let whichever owner is in a lower marginal tax bracket pay the taxes.
Keep in mind the new Secure Act calls for IRA assets to be distributed within 10 years of your death if they are left to someone other than your spouse or someone less than 10 years younger than you, plus a couple of other exceptions. So, your heirs may only have 10 years to spread out the income from a Roth conversion whereas you may have more than a decade to plan.
No. 6: If Your Estate Isn’t Large Enough
Roth conversions are often considered for those with large estates that may be subject to the estate tax at death. If a person’s assets aren’t near the estate tax exemption limit, it may not make sense for estate planning reasons.
The federal estate tax exemption is currently $11.58 million per person in 2020, although under current law the exemption is scheduled to return to $5 million with inflation, per person, at the end of 2025 — and several states have their own state estate taxes with far lower exemption amounts. By doing a Roth conversion, you would generate taxes that must be paid from your estate, thereby reducing the size of your estate and thus the amount of estate assets potentially subject to estate tax. If the value of your estate isn’t close to $5 million, it probably would not make sense to do a Roth conversion for this estate tax savings.
For instance, we have a client who was considering converting because he was concerned about the estate tax exemption going down. However, he has large pension income each year and does not have a large enough estate to be affected by estate taxes. Therefore, the conversion would just push him into an unwanted tax bracket without any estate tax benefits.
Converting to a Roth IRA is an irreversible taxable transaction thanks to a recent change in law. Therefore, you should evaluate your situation from all angles to make sure that it is appropriate before making that conversion.
About the Author
Wealth Adviser, Brightworth LLC
Bud Boland is a Wealth Adviser at Brightworth and has devoted his career to working with high net worth and high-income individuals and families. Bud works closely with clients to understand their needs and develop customized financial plans to help them reach their short- and long-term goals. Bud is a CERTIFIED FINANCIAL PLANNER™ practitioner and received his Bachelor of Science in Financial Management with an emphasis in Financial Services from Clemson University.
Wealth Adviser, Brigthworth
Patricia Sklar is a wealth adviser at Brightworth, an Atlanta wealth management firm. She is a Certified Public Accountant, a CERTIFIED FINANCIAL PLANNER™ practitioner and holds the Chartered Financial Analyst® designation. Sklar uses her CPA and investment background to help develop and implement financial planning strategies for high-net-worth and high-income earning individuals.