Some pros and cons of Roth conversion

By Elliot Raphaelson
Posted on December 26, 2023

Because of retirement-related federal legislation passed in the last few years, many individuals are considering converting some or all of their traditional IRAs to Roth IRAs.

One major reason is that most beneficiaries of traditional IRAs other than surviving spouses are no longer allowed to “stretch” distributions from their traditional IRA inheritances over their lifetime.

Moreover, if the owner of the IRA has begun taking yearly required minimum distributions (RMDs), then not only does the beneficiary have to withdraw all of the IRA balances within 10 years after the inheritance, but he/she must also take RMDs for years 1-9 based on the owner’s single life expectancy.

For any distributions from a traditional IRA, the beneficiary is required to pay ordinary income tax. If the inheritance is high, at the end of the tenth year, the beneficiary can face a large income tax bill.

For all these reasons, an owner of a traditional IRA who wants to minimize the future income tax liability for his/her heirs might consider converting traditional IRA funds to a Roth IRA. In addition to the tax advantages for heirs, the owner of the IRA, especially if he/she expects to live a long time, will receive the benefit of tax-free income and no capital gains tax on the Roth assets.

On the other hand, all conversion amounts are taxable at ordinary income tax rates in the year of the conversion, so the owner has to weigh the benefits against the immediate tax liability associated with the Roth conversion.

There are other reasons not to convert, as IRA expert Ed Slott has addressed in a recent monthly column on his website, IRAhelp.com. Here is a summary:

—Inability to pay the tax bill: All Roth conversions are subject to immediate income tax liability in the year of conversion. Before you convert, you should estimate your income tax liability for that year.

Under current tax regulations, you can’t change your mind after you convert. If you are under 59 1/2 years old and plan to pay the tax bill from an IRA account, you will be incurring a 10% penalty as well.

Don’t convert if there is a high possibility that emergency financial needs will arise, necessitating the use of the funds you would otherwise use to pay your increased income tax bill.

—Exposure to stealth taxes: When you convert, you are increasing your taxable income in the year of conversion, which can impact other taxes. For example, your Social Security taxes could increase. You could lose valuable tax credits and deductions as a result of higher income.

Another consideration is the possibility of higher premiums for Medicare Part B and Part D two years after the year of your conversion.

—Loss of college financial aid: Any additional income must be reported on financial aid forms such as FAFSA and CSS, and it could reduce or even eliminate sources of financial aid.

—Losing future tax breaks: If you have been using qualified charitable distributions (QCD) to reduce your taxes, you will lose that advantage if you convert all of your traditional IRAs to a Roth account. The QCD option is not available from Roth accounts.

—Charity as beneficiary: Qualified charities do not pay income tax on gifts from IRAs. If your objective is to leave some IRA funds to a charity, don’t convert these assets to a Roth. Why pay taxes on a Roth conversion if the charity would not pay taxes on a contribution from a traditional IRA account?

—Waiting time: After you convert from a traditional IRA to a Roth, there is a five-year waiting period before you can withdraw earnings tax-free from your Roth account (assuming you have reached 59 1/2). You can withdraw the principal amount you converted at any time tax-free without penalty, even if you have not reached 59 1/2.

The bottom line: There are definite advantages to you and your beneficiaries associated with Roth conversions. But there are some potential disadvantages that you have to consider.

It may be to your advantage to do partial conversions each year to avoid the higher taxes associated with higher marginal tax brackets, as well as other disadvantages.

Elliot Raphaelson welcomes your questions and comments at raphelliot@gmail.com.