Converting from a traditional IRA to a Roth IRA seems like a simple idea at first. Simply transfer the money from your traditional IRA to your Roth IRA, pay some taxes and you are ready to start receiving tax-free income from your Roth IRA throughout your retirement. Everybody loves the idea of tax-free income. However, there are some major disadvantages and some risks the can actually reduce your wealth rather than increase it. The tax situation is not as simple as it seems to be.
All of the money that you transfer from your traditional IRA to your Roth IRA gets added to your ordinary income for the current tax year. This can increase your marginal federal and state tax brackets subjecting any additional income you earn this year to a higher level of taxation. The odds are that you will be in a much higher tax bracket in the current year than you will be later on when you’re taking distributions from your IRA.
I was looking at an IRA Account at Schwab and I was trying to compare the benefits of a ROTH IRA vs the Traditional IRA. It turns out that the conversion is not always a no-brainer as most people believe. People often overlook the risk that the increase to your adjusted gross income can also eliminate your eligibility for many tax credits and reduce your itemized deductions. The AGI increase can also reduce or eliminate any subsidies available to you under the Affordable Healthcare Act. This could cost you thousands of dollars.
You need to look at all of these factors in order to determine what the real cost of the transfer is to you in the current year. This task practically requires you to do your entire tax return in advance just to figure out how much it’s really going to cost you.
Once you have a good idea of what your tax cost will be, you need to do some present value calculations to make sure that the transfer actually increases your total after-tax return over time. There are a number of online calculators the can help you with this mathematics. The problem is that there a lot of variables and you are playing a giant guessing game. You have no real idea what your tax situation is going to be like in the future. Often, the results of these calculations are that you only end up with more money if you keep working hard and stay in a high tax bracket.
Another major variable and thus another major risk, is the government. The government could change the rules of the game at any point in time. They could:
1) Eliminate or reduce the tax-free status of the Roth IRA.
2) Reform taxes so that all the tax brackets are lower.
3) Eliminate the income tax entirely and replace it with a consumption tax.
You really have no idea of what is going to happen.
Conversely, you can assume that government inertia will continue and things will stay pretty much the same as they are now. Plus, there is just as much chance of marginal tax rates going up as there is of them coming down. Under this scenario, there are a few benefits to converting from a traditional IRA to a Roth IRA.
One would be income flexibility. Maybe you are still working but would like some extra money to use to purchase a second home or take a special vacation. The tax-free funds from your Roth IRA are perfect for that purpose.
Tax-free withdraws from your Roth account will not increase your adjusted gross income. Thus, enabling you to take extra advantage of tax deductions and subsidies at a time when they are of more value to you. Also, unlike with a traditional IRA, withdraws are never mandatory so your money can keep growing tax-free for as long as you want.
You are probably starting to wonder why with all the risks and uncertainties you would want any kind of IRA. The answer to that has nothing to do with taxes. The number one benefit of any kind of IRA is asset protection. An IRA is the safest place to protect your money from lawyers, bill collectors, and tax collectors. Even bankruptcy judges can’t touch the first $1,000,000.
Regarding conversions, you need to look at all of the factors and decide what is best for you as both forms have their advantages and disadvantages. Most financial planners counsel their clients to have money in both types of plans. So, maybe you want to convert some or all of your current traditional IRA into a Roth IRA now but continue making tax deductible contributions to a traditional IRA. This will give you the ultimate flexibility when you need it most.