Roth Conversions: Pros and Cons

While regular contributions to Roth IRAs are allowed only for those under a particular income limit, there are a couple of loopholes that allow individuals to build up a Roth portfolio, even if their incomes exceed these limits.  One possibility is to contribute to a Roth 401(k) if your employer plan includes that option.  Another possibility is to convert contributions from a traditional IRA to a Roth IRA.  Here we will discuss the pros and cons of Roth conversions.

Pros.  By making a Roth conversion, you can enjoy all the benefits of a Roth IRA, despite exceeding the income limit for regular Roth contributions.  These benefits include:

• Tax-free distributions. You can withdraw your initial investment and earnings tax-free, provided that 5 years have elapsed since the taxable year in which you first made a contribution to the Roth and you are either age 59 ½ or the withdrawal is made on account of disability or death.
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• No Required Minimum Distributions (RMDs).  You are not required to withdraw a specific proportion of funds from the account every year once you reach age 70 ½, as is the case with traditional IRAs.
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• Tax- and penalty-free withdrawal of initial contributions.  Since you have already paid income tax on the amount that you initially contribute or convert to a Roth, you do not have to pay any tax or penalty on the withdrawal of that amount, even if you are not yet age 59 ½.
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• Tax- and penalty-free withdrawal of earnings under “first home” exception.  You can also withdraw investment earnings tax- and penalty-free if they are used toward a first-time home purchase (up to $10,000).
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• Penalty-free withdrawal of earnings under other exceptions.  Even though you may have to pay income tax on the withdrawal of earnings under age 59 ½, you will not pay the additional 10% penalty if the funds are used for qualified higher education expenses, health insurance while unemployed, etc. (See here for a complete list.)

Roth IRAs can be very useful in managing taxes in retirement (e.g. you can utilize tax-free withdrawals from the Roth to supplement taxed withdrawals from your traditional IRA or 401(k) in order to meet cash flow needs while staying in a lower tax bracket than if all funds came from a 401(k) or traditional IRA).  Also, since there are no RMDs, Roth IRAs can be a useful estate planning tool, providing an asset from which your heirs can withdraw money tax-free throughout their lifetimes.

Cons.  The main risk of contributing or converting funds to a Roth IRA is the possibility that the tax advantages that you anticipate from the Roth will somehow not come to fruition.  Possible drivers of this may include:

• Lower tax bracket in retirement.  Your tax bracket may decrease between when you paid tax on the funds and when you withdraw them, perhaps because you have more income now than you will in retirement or perhaps because Congress changes tax rates and your marginal tax rate ends up lower.
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• Congress changes the rules of the game.  Congress could also change the tax law to alter the benefits of the Roth.  For example, Congress could make Roth withdrawals subject to income tax–either for all account holders or for those above a certain income level.  This happened in the past with Social Security benefits, which previously were not taxed, and now may be taxed on up to 85% of your benefit.
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• Congress could diminish estate planning benefits.  In his 2015 budget proposal, President Obama suggested instituting RMDs for Roth IRAs and forcing non-spouse beneficiaries of inherited Roth IRAs to withdraw the funds over five years (rather than over the course of their whole lifetimes, called “stretch withdrawals”).  Congress did not approve this proposal, but it could resurface in the future, which would reduce the benefits of Roth IRAs as an estate planning tool.
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• Penalties for early withdrawals.  If you do need all of the funds (including investment earnings) from your Roth prior to age 59 ½ or within the 5-year waiting period, you may have to pay income tax and the 10% penalty on earnings.  Depending on your age and future cash needs, you might be better off simply investing them in a taxable investment account.

If you are wondering whether a Roth conversion might be beneficial for you, please give us a call, and we’ll talk through the pros and cons in light of your specific situation.