Converting a traditional Individual Retirement Arrangement (IRA) to a Roth IRA is often a terrific strategy for many federal employees and retirees. But there are various reasons an Roth IRA conversion may not be the best decision for some.
First, some background information on Roth IRA conversions is presented. Effective Jan. 1, 2010, Congress has allowed any individual, no matter the individual’s age, tax filing status, or income level to perform full or partial conversions of a traditional IRA to a Roth IRA. Since then, traditional IRA owners have performed more than $75 billion of traditional IRA to Roth IRA conversions.
There is no doubt that the benefits of a Roth IRA conversion are manifold. A conversion results in retirement funds going into an account that offers both tax-free growth and tax-free withdrawals. Also, the Roth IRA is the only type of tax-favored retirement account in which the retirement account owner is not subject to minimum required distributions (MRDs) starting the year the owner becomes age 70.5.
But there are disadvantages to converting a traditional IRA to a Roth IRA. Federal and state income taxes must be paid in full in the year of conversion. Also, the danger is that the IRA owner will give up tax-deferred growth in the traditional IRA without reaping even more valuable tax-free benefits in the Roth IRA.
The following are other reasons or conditions that may make a Roth IRA conversion an unwise move:
The IRA owner’s marginal tax bracket is going down
In general, it does not make sense to perform a Roth IRA conversion if the IRA owner’s marginal tax bracket is expected to be lower compared to the time when withdrawals from the IRA are made. This means it is often best to convert when one is in a lower marginal tax bracket, usually at a time when income dips. For example, federal employees who change jobs or retire from federal service and plan to move to a state with no or lower state income taxes compared to the state in which they have been contributing to their traditional IRAs should consider delaying their conversions.
The IRA owner does not own a sufficient amount of liquid assets held outside the IRA
Any IRA owner considering a Roth IRA conversion should have enough liquid assets held outside in a non-retirement account to pay the income taxes due on conversion. Paying the income taxes due with IRA assets decreases the amount of the IRA that can grow tax-free.
The IRA owner is concerned that the IRA will decrease in value after conversion
If the IRA assets lose value following a Roth IRA conversion, then the IRA owner will have paid higher federal and state income taxes than necessary. Note that under the Tax Cuts and Jobs Act of 2017, Roth IRA conversions performed after 12/31/2017 cannot be recharacterized or “undone”, even if the converted IRA subsequently decreases in value after the conversion.
A Roth IRA conversion could possibly result in a loss of tax credits and increase “stealth” taxes
Converting to a Roth IRA raises income in the year of conversion. Some tax credits and deductions could be lost if income threshold levels are exceeded. Some examples is a tax credit for paying higher education costs (the American Opportunity Tax Credit) and the 20 percent deduction for a pass-through business. Higher income in the year of a conversion could also help trigger the 3.8 percent tax on net investment income, although the converted traditional IRA assets are not subject to the 3.8 percent tax. Note that the 3.8 percent tax is in addition to the regular tax paid on investment income. The adjusted gross income threshold for this additional 3.8 percent tax is $200,000 for single filers and $250,000 for married couples filing jointly.
The Roth IRA owner needs the converted Roth IRA assets “sooner” and not “later”
Converted Roth IRAs often provide their largest benefits when the converted account grows untouched for years. If payouts from a converted Roth IRA will be taken within the first five years following conversion, then converting to a Roth IRA makes little sense. This is because the converted Roth IRA assets will not have sufficient time to grow.
A traditional IRA owner over age 70.5 makes Qualified Charitable Distributions (QCDs)
Traditional IRA owners who are 70.5 and older can donate up to $100,000 of assets per year from their traditional IRA to one or more charities and have the donations count towards their annual Required Minimum Distribution (RMD). While they do not receive a charitable deduction for tax purposes, they also do not include the TSP withdrawal in their income. This is often a highly tax-efficient move.
But Roth IRA owners do not benefit from a QCD. This may be a reason for a traditional IRA owner to not convert all his or her traditional IRA to a Roth IRA. Instead, the owner should perhaps perform a conversion on only some of his or her traditional IRAs and not all of them.
Higher education financial aid could be affected
Retirement accounts are often excluded from higher education financial-aid calculations, but income is not. This means that if the income “spike” resulting from a Roth IRA conversion could lower a higher education financial-aid award in a particular year, then the conversion should be put on hold.
The traditional IRA owner has above-average out-of-pocket medical expenses
Under current law, unreimbursed medical expenses are tax deductible if the total expenses paid exceed a threshold (7.5 percent above one’s adjusted gross income or AGI during 2018; 10 percent above AGI starting Jan. 1, 2019). For someone who has above-average medical expenses – for example, an individual living in a nursing home – the deductible expenses can reduce or even eliminate taxable income. But if all funds are held in a Roth IRA and withdrawn, then the withdrawn funds are not included in income and if used to pay medical expenses, there is no deduction for medical expenses. The opposite is true if the withdrawn funds are coming from a traditional IRA (taxable income) and used to pay qualifying medical expenses (deductible if the total out-of-pocket expenses exceed the threshold).