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By: Brian Bristow

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The Pros and Cons of Roth IRA Conversions

Saving and Budgeting | Investing in the Future

If you have money in a traditional IRA, it is worthwhile to think about converting it to a Roth IRA. Not all people will benefit from Roth IRA conversions, but it’s good to consider the pros and cons to determine the best option for you. Here’s what you need to know.


The difference between traditional and Roth

The important difference between traditional and Roth IRAs is simple. The contributions you make to a traditional IRA are potentially tax deductible during the contribution year, but they taxed when you withdraw the money during retirement. In contrast, you always pay taxes on contributions to your Roth IRAs during the year you contribute but when you retire, you withdraw the money tax-free.

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The benefits of going Roth

The common assumption, when it comes to Roth IRAs, is that tax rates will be higher in the future. If you think that will happen, you may be compelled to go Roth. After all, once you are age 591/2 and have owned the Roth for five years, you can withdraw the principal and earnings tax free. You can also withdraw Roth IRA contributions tax free and penalty free at any time after the five year holding period.


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You never have to take required minimum distributions from a Roth IRA, and you are allowed to make contributions to a Roth IRA as long as you live. Because of this, your Roth becomes a reservoir of tax-free income for retirement (provided you follow IRS rules).


Roth IRAs can also prove to be very useful estate planning tools. If IRS rules are followed, you can pass your Roth IRA funds to your heirs as a tax-free inheritance, paid out either annually or as a lump sum. In contrast, distributions of inherited assets from a traditional IRA are routinely taxed.


That’s the upside, but what about the downside?

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The drawbacks of going Roth

Two reasons you may opt to stick with a traditional IRA are that you will be hit by taxes during the year you convert and/or you may be too close to retirement to gain from the conversion.


When you convert to a Roth IRA, you will be taxed for the money you are converting. Why? Because you did not pay taxes on the funds you placed in your traditional IRA so you will have to pay those taxes during the year you convert to a Roth. Also, when you convert the IRA, you are essentially increasing your income by the amount of the conversion. As a result, you could find yourself in a higher tax bracket for that year.


If you are nearing retirement age, going Roth may not be worth it. If you convert a sizable, traditional IRA to a Roth when you are in your fifties or sixties, it could take a decade (or longer) to recapture the dollars lost to taxes during the conversion. You will want to determine, with your tax advisor, if you will be able to recoup the tax dollars before you decide to convert.


Some additional arguments to consider

For those who are concerned about higher taxation in the future, the counter-argument is that because you will be retired, you will be in a lower tax bracket than you were during your working years so that taxes you’ll pay on distributions from your traditional IRA could potentially be lower.


Another argument is that paying taxes on Roth contributions HURTS the pocketbook. If you don’t have a lot of money to begin with, the tax burden can feel overwhelming. People who don’t make a lot of money may use taxes as a reason not to invest in Roth. However, a good practice is to increase the amount of your Roth contributions as you earn more over the years.


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Options for those who are on the fence

If you’re not sure which option is best for you, there are some “in between” options you may want to consider.


Do a partial conversion

If your traditional IRA is large, you could make multiple partial Roth conversions over time. By choosing this option, you can spread the tax consequences of the conversion out over time while also keeping within your current tax bracket. Since each conversion adds to your income by the amount you are converting, you will want to determine how much you can convert before you will be placed in a higher tax bracket.


Invest in both

Because no one can predict the future of taxes, some people contribute to both Roth and traditional IRAs—figuring that they will at least be “half right,” regardless of whether taxes increase or decrease.


Undo the conversion

If you convert to a Roth and don’t like it, you can “recharacterize” (i.e., reverse) the conversion. The IRS gives you until October 15 of the year following the initial conversion to “reconvert” the Roth back into a traditional IRA and avoid the related tax liability.


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Representatives are neither tax advisors nor attorneys. For information regarding your specific tax situation, please consult a tax professional. For legal questions, including a discussion about estate planning, please consult your attorney.


Representatives are registered, securities are sold, and investment advisory services are offered through CUNA Brokerage Services, Inc. (CBSI), member FINRA/SIPC, a registered broker/dealer and investment advisor, 2000 Heritage Way, Waverly, Iowa 50677, toll-free 800-369-2862. CBSI operates under the marketing name of MEMBERS Financial ServicesTM. Insurance sold through licensed CUNA Mutual Life Insurance Company Representatives, and in New York, licensed insurance representatives of other companies.  Nondeposit investment products are not federally insured, involve investment risk, may lose value and are not obligations of or guaranteed by the financial institution. FR-3194438.1-0820-0922

About Brian Bristow

Brian Bristow is the program manager and financial advisor with MEMBERS Financial Services located at VSECU.