Advantages and Disadvantages of Roth IRA Conversions

April 27, 2024

The ability to invest on a tax-deferred basis is limited under current tax policy. One of the options that is available is a Roth IRA, which has the added benefit of allowing for tax-free distributions.

A Roth IRA allows you to contribute after-tax dollars and withdraw any earnings tax-free in retirement. On the other hand, while you typically get a tax deduction on contributions to a traditional IRA (and the money grows tax-free), you pay taxes when you withdraw the money in retirement. For these reasons, many people consider a Roth IRA conversion to move money from a traditional IRA to a Roth IRA. While there are income limits on who can invest in a Roth IRA, there are no income limits for conversions, so those who would otherwise be ineligible may be able to utilize a Roth IRA conversion. It can be a powerful strategy for retirement, but the advantages and disadvantages should be carefully considered with your tax advisor to determine what’s best for your specific situation.

Advantages

There is a possibility that you will pay less taxes overall with a Roth IRA than a traditional IRA if it seems likely that you’ll be in a higher tax bracket in the future. After-tax dollars are used to make contributions to a Roth IRA, so no further taxes will be due, assuming you take a qualified distribution. Although there are no tax deductions with a Roth IRA, contributions and earnings will grow tax-free.

In addition, contributions (but not earnings) can be withdrawn tax-free at any time (because you have already paid taxes on the contributions) from a Roth IRA. And, there are no required minimum distributions (RMDs) from a Roth IRA when you reach age 72, so if you don’t need these funds, they can remain in your account to be passed on to your beneficiaries.

Disadvantages

Paying income tax at the time of conversion, which could be substantial, is the primary disadvantage of converting to a Roth IRA. If you anticipate having a lower income tax rate in the future, there may be no tax benefit to doing a Roth IRA conversion. In addition, calculating the amount of taxes can be complicated if you have other traditional, SEP, or SIMPLE IRAs that you’re not converting.

Also, you must reach 59 ½ years of age and keep funds in your new Roth IRA for five years before taking any tax-free withdrawals. If not, you may incur a 10% early withdrawal penalty, in addition to paying taxes on earnings (unless you qualify for a limited exception).

It is generally preferable to use funds other than funds from your IRA to pay taxes due as a result of the conversion. Any funds taken out of your IRA to pay taxes would be considered a distribution and could result in higher taxes than expected in the year of the Roth IRA conversion, especially if there are any penalties as a result of the withdrawal. For this reason, taxes should be paid from another source, provided there are sufficient funds available in another account.

What is Your Tax Planning Strategy?

Have you explored what tax planning strategies might be available to you? Many factors should be considered in determining a strategy that meets your objectives and gives you the best overall tax savings. In a year where there’s so much uncertainty in tax laws, it’s important to have experienced advisors to assist you. First Western Trust can help you implement a tax-effective planning strategy.

About First Western

In 2002, Scott Wylie, an entrepreneur, and banker led a group of Western business leaders to create an organization that provides individuals with high levels of sophistication and personalized boutique service. The result of this effort is the first Western-based private bank – First Western Trust.

We believe that each of our clients shares our entrepreneurial spirit and values our sophisticated, high-touch wealth management services. We offer a trusted advisor platform with an established approach to investment management through a branded network of private boutique offices.

To learn more, visit us online at www.myfw.com.