Recently I heard a radio ad that asked: “Will your traditional IRA cost you thousands in taxes?” The financial planner asking this question suggested he could help convert your traditional IRA into a ROTH IRA and eliminate future taxes. This certainly sounds intriguing, especially when he added: “You don’t know how much of the money in your IRA is really yours,” implying that you will have to pay taxes on future withdrawals.
It is true that withdrawals from your traditional IRA are subject to taxes. These withdrawals are currently taxed at your ordinary income tax rate during the years you take money out. But, if you convert to a ROTH, you create taxable income—and the taxes on this are due for the year of conversion, rather than spread out when you take distributions during retirement.
The benefit of your traditional IRA comes from the combination of contributing pre-tax income, which effectively increased your deposits, and the tax-deferred growth of earnings and gains within this account. This dual tax advantage was designed to foster powerful compounding of your investments. The government offers this so that you will save more for your retirement years. In exchange, you only owe taxes when you take money from your IRA. And for many of us, our tax rate is lower in retirement than while we were pursuing a career. That is a powerful consideration when contemplating a ROTH conversion.
Here are bullet points to consider before making a ROTH conversion:
- Do you expect your tax rate to be lower in the future? For many of us, our tax rate is expected to be lower in retirement. So, pre-paying taxes at a higher rate before retiring may not make sense.
- Consider what tax bracket you may move to due to the additional income you’ll incur from a conversion. Money taken out of your traditional IRA—even for the purpose of converting it to a ROTH—is considered taxable income.
- Do you have available funds outside your IRA to pay the taxes due from a ROTH conversion? If you don’t, then the amount that makes it into your ROTH will be noticeably lower, affecting the ability to compound your earnings in a tax-friendly way during retirement.
- Do you expect to make charitable contributions to a church or qualified charities during your retirement years? If you do, you can currently give up to $108,000 a year directly from your IRA (subject to other limitations) without this impacting your income. Furthermore, this can be used to reduce your RMD for any year you are required to take one (again subject to various rules).
- How much do you trust the government to leave the benefits of ROTH IRAs alone in the future? Some promoters of ROTH conversion strategies pair their recommendation with a warning that the government could raise taxes in the future. Perhaps, but if they’re being honest, they also don’t know what future changes may lie in store for the rules surrounding ROTH IRAs.
- When do you expect to withdraw money from your ROTH IRA? If you withdraw funds from your ROTH IRA within five years after first contributing, or if you withdraw funds you’ve converted before letting them sit in your ROTH IRA for five years, taxes and penalties may apply.
- Most non-spouse individual heirs will be subject to a 10-year RMD rule (under current regulations) regardless of whether you have a traditional or ROTH IRA.
We’re not against Roth accounts—in fact a few of us have these. We’re just cautious about people who advertise fear to urge you to make irreversible financial decisions. Converting all or part of a traditional IRA to a ROTH can make sense, especially if your tax rate is unusually low during a particular year. Generally speaking, however, traditional IRAs do not create horrible tax consequences, and these are effective accounts to save and invest for your retirement.
Do you want to know more? Give us a call! We are ready to help you and your tax advisor if you’re considering a ROTH conversion.
Disclaimer: This information is for general knowledge and does not constitute financial or tax advice for specific individuals. Be sure to consult your tax advisor before making any decisions.
Eric Ball, CFA
Managing Director
America First Investment Advisors, LLC
Omaha, Nebraska
This post expresses the views of the author as of the date of publication. America First Investment Advisors has no obligation to update the information in it. Be aware that past performance is no indication of future performance, and that wherever there is the potential for profit there is also the possibility of loss.
