Why Converting to a Roth IRA Is a Mistake

Article Summary:

  • The $100,000 income limit for Roth IRA conversions has been lifted
  • For most of you, converting to a Roth is a mistake.
  • There is one group of individuals who would probably benefit by doing the Roth conversion.

Many of you have by now heard that 2010 is the year to convert your traditional IRA to a Roth.  Not only has the $100,000 income limit been lifted (now anyone, regardless of income can convert to a Roth), but the income generated by the conversion in 2010 can be deferred, 50% to 2011 and 50% to 2012.  Combine these bonuses with the fact that tax rates are almost guaranteed to be going higher, and you can see why the financial media has proclaimed that converting to a Roth is a no-brainer.

Well I’m here to tell you it is not.  For most of you, converting to a Roth is a mistake.  The most serious error that most people make in their thinking is that even though tax rates might be higher when the IRA money is withdrawn in retirement, the average tax rate at that point will most likely be lower than the marginal tax rate for the currently employed individual.

For example, a married individual currently earning $100,000 a year, probably is in a combined Federal and state 30% tax bracket.  Converting $50,000 to a Roth would probably cost him about $15,000 in additional taxes even if the income were spread over two years.  However, if that same individual were to withdraw $50,000 from his traditional IRA in retirement, the money would be taxed at various tax brackets starting at 0% and moving up to 15%, and then maybe 25%.  His average tax rate would most likely be closer to 15%.  His total tax bill would be about $7,500 and wouldn’t have to be paid until years after the individual who converted in 2010 paid his taxes.

Another example would be a retired individual younger than 70 1/2, and who therefore hasn’t begun making withdrawals from his traditional IRA.  He thinks that since his income is now low, it would be a good opportunity to reduce the size of his IRA by converting some of it to a Roth.  Let’s say that he is 66, has a $1 million IRA, and decides to convert $40,000 in 2010.  Spreading the income over two years, he would probably pay 15% tax on the $40,000 or an additional $6,000 in taxes.  How much would he save by doing this?  Well in 5 years, assume that he has about $40,000 less in his IRA.  This would reduce his required minimum distribution from his IRA by about $1,500 ($40,000 / 26.5).  If his tax bracket in that year increases to 20%, his tax bill for that year and subsequent years would be about $300 less than if he hadn’t done the conversion.  So you would have to pay $6,000 during the next two years to save $300 a year starting in five years.  The math doesn’t make sense.

There is one group of individuals who would probably benefit by doing the Roth conversion. These are those fortunate ones who will have lifetime pensions when they retire.  For them, their average tax rate on their IRA withdrawals in retirement will probably be the same or even higher than their current marginal tax brackets.  So doing the conversion and paying the tax over the next two years makes sense for them.  But for everyone else, keep your money in your pocket and leave your IRA accounts alone!

About the author

Jeff Feldman, Ph.D.,CFP®

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