(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:
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.
|Overnight Avg Rate||Latest||Change||Last Week|
|30 yr fixed||3.59%||3.65%|
|15 yr fixed||2.73%||2.78%|
|30 yr refi||3.63%||3.69%|
|15 yr refi||2.77%||2.81%|
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