The advantages of having a Roth IRA are clear:
• Since contributions to a Roth IRA come from after-tax dollars, those savings grow tax free.
• Contributions and earnings can be withdrawn tax free after age 59 1/2 (if the account is at least 5 years old).
• Contributions can be withdrawn tax free at any age.
Earnings withdrawn before age 59 1/2 (and before the 5 year holding period) will incur taxes and a 10% penalty.
• A first-time home purchase ($10,000 lifetime maximum), qualified education expenses, birth or adoption expenses,
and certain emergency expenses qualify as exceptions to the rule concerning withdrawals before age 59 1/2.
• Required Minimum Distributions (RMD's) are not required.
With these advantages, however, come some limitations. A Roth IRA has an annual contribution limit of $7,000/year ($8,000 if you are over 50) and is available only to those with annual adjusted gross income of less than $161k
($240k, if married). The contribution limit is almost 70% less than 401k plan limits and applies to any and all IRA accounts combined, not each account. This may be restrictive for those wanting to save much more to a Roth IRA.
However, if you don't qualify for a Roth IRA, or want to contribute more than the limit, there is a loophole - a Traditional 401k/IRA can be converted to a Roth IRA without adhering to the contribution/income limits. This may sound tempting, primarily because future withdrawals would be tax-free (saving a lot of money), but it's not a slam-dunk.
There are possible pitfalls that need to be considered before proceeding:
• To convert funds from a Traditional account to a Roth account, you will have to pay taxes on the amount converted (remember that you did not pay taxes on those contributions originally, and won't pay taxes in the future if they are in a Roth IRA, so the I.R.S. wants their cut). Those taxes are due in full in the year the amount is converted. You also can not wait until you file your taxes at the end of the year to pay the tax bill on the conversion. You must pay the taxes as part of your estimated quarterly taxes.
• You will want to pay the taxes on the conversion with non-retirement savings. Taking money out of retirement savings to pay the taxes will only increase the tax bill, while reducing the savings available to produce future income.
This is never recommended. Do you have the money to pay the taxes on the conversion outside of your 401k/IRA?
• You will be taxed on the conversion amount at your current tax rate. If your future tax rate will be significantly lower than your current rate (Retiring soon? Working part-time for a few years before retiring?) a conversion may not make sense. There would be no reason to pay higher taxes now than you would on taxable withdrawals later. For example,
if you have $100,000 in income now and do a $100,000 conversion, the Federal tax rate applied to the $100,000 conversion would be ~16.2% ($200k less the Standard Deduction for a married couple). If you withdrew $25,000/year for 4 years from a Traditional 401k/IRA (in retirement), the tax rate would be ~10% per year. You would pay ~$6,000 less in taxes not doing the conversion. To figure out if a conversion makes sense, always consider your current and future tax rate.
• Once a conversion is completed it will take time (~4-5 years, depending on your return rate, and with no withdrawals) for that conversion to be justified by the tax savings. The money that was spent on taxes (even though it was from non-retirement funds) needs to be earned back to break even. Only after earning back the "cost" of the conversion will the tax savings of having a Roth IRA begin to accrue. If you will start withdrawing funds in the near future (within 4-5 years), a conversion may not be the best option. Also, don't forget that withdrawing any of the converted funds before
age 59 1/2 will require paying taxes on any earnings, along with a 10% penalty.
• If you are on Medicare, or will be within two years, be aware that the conversion will add to your taxable income (which is why you owe taxes on it), and may trigger Medicare's IRMAA (Income Related Monthly Adjustment Amount) which could significantly increase the Medicare premiums that you pay for Parts B and D. IRMAA considers your taxable income from 2 years prior. This could add up to hundreds of dollars a month more in premiums, quickly eating into any tax savings from the conversion. If your income becomes high enough, it could even trigger a 3.8% Medicare surtax on top of increased premiums. IRMAA only affects a small percentage of households, but you should be aware of it.
• A Roth conversion can also affect your Social Security income. If you are already receiving Social Security, the conversion amount counts as taxable income, which can easily raise the taxable amount of Social Security income. You may or may not be taxed on part of your benefit now, but a higher income level (above $44,000 for married couples) can cause up to 85% of your benefit to become taxable.
• If there is any chance that you will need some degree of asset protection in the future (e.g. creditors, law suit, any possibility of a divorce, etc.) you should be aware that in some States a 401k, SEP, or other qualified retirement plan offers more protection than an IRA.
With the right timing, a Roth conversion can make a lot of sense. But before accepting it at face value, make sure to factor in all of the benefits and all of the possible pitfalls to make sure that it makes sense for your particular needs and situation.