Our Terms of Service and Privacy Policy have changed.

By continuing to use this site, you are agreeing to the new Privacy Policy and Terms of Service.

Roth conversions: Beware the hype

By Walter Updegrave, senior editor


(Money Magazine) -- Since the ban on converting to a Roth IRA by folks making more than $100,000 was lifted this year, the buzz surrounding conversions has been deafening.

Everywhere you turn, some adviser or investment firm is blaring the benefits of switching to a Roth: Tax-free withdrawals! Tax-free returns! A tax-free legacy for heirs! But before you hop on the bandwagon, keep the following in mind:

walter_updegrave__2009b.03.jpg
Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).

Roths are no free lunch

A few months ago, I wrote that most people should at least consider converting a portion of their traditional IRAs. So I'm the last person to rain on the Roth's parade. But I also emphasized that a Roth was no freebie.

To get a Roth's tax-free benefits in the future, you'll have to pay taxes today. That means a conversion makes the most sense if you think you'll face a higher tax rate -- or for that matter the same rate -- when you pull money out at retirement. And a Roth makes more sense if you can pay the levy from funds outside your IRA.

True, a conversion can pay even if you drop into a lower bracket down the road. But time is a huge factor. Depending on what bracket you fall into, it could take years and possibly decades for the Roth's tax-free compounding to make up for the taxes paid at conversion.

So if you intend on cashing out as soon as you're allowed -- rather than, say, preserving your Roth for your heirs -- a conversion may not make a lot of sense.

Conversions can cause unexpected tax hits

Unless your conversion includes after-tax dollars -- say, from a non-deductible IRA -- the entire amount you convert becomes taxable income. So the conversion itself can kick you into a higher tax bracket.

Also, income generated by the conversion can reduce your ability to deduct certain expenses. For instance, you can deduct only those medical costs that exceed 7.5% of adjusted gross income. But if the conversion boosts your AGI, you might lose some or all of those medical deductions.

The added income can also trigger or raise taxes on Social Security benefits. In some cases, it could also subsequently boost your Medicare premium. There are ways around these drawbacks, such as converting small amounts over several years. But you have to know the ramifications.

Beware of pitches

Insurance sales organizations are encouraging advisers to push annuities at conversion. That's not to say an annuity can't ever make sense in a Roth. But those with high fees can be inappropriate.

Bottom line: Don't convert unless you've studied the numbers. Online calculators may be able to help somewhat, but, frankly, if you're thinking of converting a large amount, have a financial planner do a more thorough analysis.  To top of page

Overnight Avg Rate Latest Change Last Week
30 yr fixed3.85%3.87%
15 yr fixed2.96%2.98%
5/1 ARM3.14%3.19%
30 yr refi3.96%4.00%
15 yr refi3.06%3.08%
Rate data provided
by Bankrate.com
View rates in your area
 
Find personalized rates:
Index Last Change % Change
Dow 16,578.44 -76.33 -0.46%
Nasdaq 4,809.60 -3.11 -0.06%
S&P 500 1,980.93 -6.73 -0.34%
Treasuries 2.19 0.02 0.83%
Data as of 3:23pm ET
Company Price Change % Change
Freeport-McMoRan Inc... 10.49 0.30 2.94%
Bank of America Corp... 16.30 -0.14 -0.82%
Apple Inc 112.68 -0.24 -0.21%
Alcoa Inc 9.36 0.51 5.70%
Intel Corp 28.46 0.74 2.68%
Data as of 3:08pm ET

Sections

Efforts to unionize low-wage employees of fast-food franchisees and outside contractors get lift from decision of NLRB. More

After Hurricane Katrina, the city of New Orleans had to reinvent the way it manages water and protects itself from future storms. More

The market volatility in China and the U.S. could hit private companies, especially late-stage unicorns. More

How do you run a successful crowdfunding campaign? Indiegogo's CEO Slava Rubin offers his top tips and mistakes to avoid. More

Mom and pop investors are dumping their investments and moving to cash at levels not seen since the financial crisis of 2008. More