The income constraints are gone: now anyone can convert a pre-tax IRA or 401(k) plan assets into a tax-free Roth IRA.
All you have to do is pay ordinary federal and state income taxes on your pre-tax IRA, and you’ll have created a fund from which no taxes will ever be due.
So should you take the bait? Maybe yes and maybe no. Here’s a look at both sides of the issue:
Reasons to Convert Your IRA or 401(k) to a Roth IRA
1. You’re young.Younger investors who anticipate being in a higher tax bracket in the future should consider paying the tax now at their lower marginal tax rate and converting the funds to a Roth IRA. Since the Roth IRA is tax-free (and not just tax-deferred), your money will grow tax-free forever, and you avoid giving Uncle Sam a bigger share of the funds you withdraw from your IRA.
2. You have good retirement cash flow. Older investors who won’t need to take distributions starting at age 70 ½ might be better off in a Roth IRA. With a traditional IRA, you’re required to take minimum annual distributions at age 70 ½ that will trigger the payment of taxes on those distributions.
3. You’re doing estate planning. If you don’t anticipate needing your IRA funds during your lifetime, a conversion to a Roth IRA, which you then leave to your heirs, can be a way to ensure fond memories. The tax-free withdrawals can be prolonged over the lives of your heirs, turning a small gift into a huge inheritance.
4. You’re single. If you were filing jointly with your spouse and are now single (through divorce or death of a spouse), conversion might make sense. Married couples get more favorable tax rates. As a single filer, you could benefit from taking distributions tax-free.
Reasons Not to Convert Your IRA or 401(k) to a Roth IRA
1. You’re headed for a lower tax bracket.Older investors who are in a high tax bracket now but anticipate being in a lower one in the near future shouldn’t convert to a Roth IRA. When considering your future tax bracket, don’t forget state taxes. Many retirees move from higher tax states to those with no state income tax (like Florida). Be sure to take both your federal and state taxes into consideration when contemplating an IRA conversion.
2. You’re planning to pay the tax bill with your IRA funds. If you’ll be paying the taxes owed when converting a traditional IRA with IRA funds, you might be better off not converting. This is especially true if you’ll incur penalties in addition to taxes by converting to a Roth IRA. If you can use non-IRA funds, a conversion could make sense.
3. You’re planning to leave your money to charity. If you’re an older investor who intends to leave your IRA to a charity, you should not convert your IRA funds to a Roth IRA. Check with your estate lawyer, but you will probably be better off excluding the larger pre-tax IRA from your taxable estate. The charity won’t care. It doesn’t pay any income tax.
4. You’re worried about asset protection. If this is a concern, converting your 401(k) to a Roth IRA may give you less protection. Investors who are in high-risk professions (like physicians) or who are being hounded by creditors should have their lawyers check the state laws where they reside to determine if their assets are more vulnerable in a Roth IRA than in a 401(k).
The conversion decision is not uncomplicated. Investors should seek the advice of their accountants or tax advisers before making the leap to a tax-free Roth IRA.
Have you decided to take the conversion plunge? What tipped the scales for you?
Dan Solin is a best-selling author, a wealth advisor with Buckingham, and the director of investor advocacy for the BAM Alliance.