ROTH Conversions and Why They May Not Work For You
Sure, there are many advantages of ROTH conversions, but they may not be good for everyone. In circumstances where the taxpayer has to pay a lot in taxes upfront for conversion and the taxpayer is near retirement. Below we will further explore this topic.
Background
Withdrawals for ROTH IRAs are tax free because the taxpayer pays the tax upfront at the time of investment. ROTH IRAs also have no withdrawal requirements, while traditional IRAs require investors to start withdrawing at age 70 ½. ROTH IRAs have the advantageous component of not requiring tax on investments or on the accumulated interest. There are however income limitations for ROTH IRAs, though these have been temporarily suspended by Congress.
Caveats
- Beware of Hefty Taxes Upfront
When converting your traditional IRA into a ROTH IRA you will need to pay income taxes on the withdrawal. You should consider whether you can afford to pay these taxes, and if it makes sense for you. Some investors may worry about their liquidity and take caution when dispensing their cash in such a tight credit market. It is also important to consider whether the taxes paid in the conversion will be recovered in the remaining years of the ROTH IRA. It often takes 15 to 20 years to recover those taxes, not including any extensions triggered by early withdrawals.
- Be Careful of Climbing Income Tax Brackets
If you are not in a high income bracket, it’s important to consider that as soon as you convert to a ROTH IRA, that money will be treated as income. This increases your income and your tax bracket.
This should also be taken into consideration by people receiving social security benefits, as they may have to pay taxes on those benefits. Also, this conversion may be further complicated if investors have children who are receiving financial aid for their college tuition.
