Due to recent market declines and the changes in conversion rules for 2010, there’s been a lot of interest in converting traditional IRAs to Roth IRAs lately.
What worries me is that some investors seem to be focusing entirely upon whether they can convert their IRA to a Roth without bothering to determine whether they should convert it.
In that vein, I thought it would be beneficial to point out three scenarios in which it might not make sense to convert a traditional IRA to a Roth IRA.
You Expect A Lower Tax Bracket in Retirement
If you expect your tax bracket in retirement to be lower than your 2011 tax bracket, converting is unlikely to be advantageous.
And no, the market being down from where it was in early 2008 does not change that fact. Paying, for example, 25% now is not better than paying 15% later, even if that 15% is on a larger total. (Remember the commutative property of multiplication? It still works.)
Please note that this means that the people who weren’t eligible in 2009 or prior years due to income restrictions but who will be eligible in 2010 (when the income restrictions are temporarily removed) are actually somewhat unlikely to be in the group who would benefit from a conversion.
You Don’t Have the Cash On-Hand
If you don’t have the cash available to pay the tax on the conversion, then it’s unlikely to be a good idea. If you use money out of the IRA to pay the tax, the amount you withdraw counts as a non-qualified distribution and will be subject to the 10% penalty if you’re under 59½. This is not a good thing.
You’re Seeking to Avoid RMDs
Something that gets mentioned frequently when discussing Roth conversions is that, unlike traditional IRAs, Roth IRAs are not subject to Required Minimum Distribution rules.
That’s true. But does it make sense to enact a Roth conversion (which is, essentially, a voluntary whole-IRA distribution) now in order to avoid Required Minimum Distributions later? I’m not convinced.
Not That Roth Conversions Are a Bad Thing…
Of course, the point of all this isn’t to say that converting your IRA to a Roth IRA is a bad idea. Many investors really would save money in the long-run by converting. But please don’t do it on the assumption that it’s automatically beneficial just because you’re eligible.