A Roth Conversion is Expensive

This myth persists and may cost you many thousands!

Merriam Webster Dictionary cites the following as the definition of Expensive – 1 : involving high cost or sacrifice.

There are only two ways to get your money in to a tax-free Roth IRA. You either make a contribution of your after-tax, earned income from employment or convert existing Traditional IRA money to a Roth IRA. Contributions are limited to $6500 per year if you are younger than age 50 and $7500 if you are aged 50+. There is no limit on how much Traditional IRA money you may convert to a Roth IRA. There is no age limitation either!

When people make a contribution of already taxed money to a Roth IRA, I’ve never heard anyone complain about the contribution being expensive. Not one time ever. Nearly every time I discuss converting not-yet-taxed money (Traditional IRA) in to a tax-free Roth IRA, I hear concerns about the “cost” or that the conversion is “expensive”. This strategy is a choice to reduce some of the tax liability that exists today, may be higher tomorrow, but is not avoidable.

This “cost” reaction is similar to a person complaining about not getting a tax refund. The only reason anybody gets a tax refund is because they paid too much tax to the IRS during the year. Your tax burden is exactly the same whether you get a refund or have to write a check. Of course it feels different! You may have heard that facts don’t care about your feelings. I respect the impact of feelings, but advise clients based on facts.

Tax Advisors may benefit if you choose not to convert Traditional IRA money to Roth IRA money. Tax Advisors are often graded by their clients based on how much tax is paid in any single year. A Roth conversion triggers taxable income in the year of the conversion, therefore in any single year the taxes paid would increase due to the Roth conversion.

Bottom line ladies and gents is this: your Traditional IRA money will be subject to income tax when distributed, and there is no way to avoid that money from eventually being distributed. The “cost” of taxes is already built in. There is no free lunch!

Your Traditional IRA includes your share and the IRS’s share (income tax upon distributing). Sure you can let your Traditional IRA grow and feel good about the value growing. Just understand that your share is growing and the share payable to the IRS grows at the same rate if tax rates stay level in the future. You may think income taxes will be higher in the future. If this becomes a reality, then your tax liability would increase due to your decision to defer taxes.

Lastly, if you are married, what are the odds you or your spouse will die first? This can be a huge tax trap as the surviving spouse must file “single” moving forward beyond the year in which their spouse dies. According to the IRS tax code, the percentage increase in going from the 12% tax bracket to the 22% tax bracket is an 83% increase in the tax bracket. For example, $50,000 taxable income to a married couple would put them in the 12% tax bracket. After the first spouse dying, that same taxable income would put the surviving spouse in the 22% tax bracket. Choosing to pay much higher taxes on your Traditional IRA money in the future would seem to be much more expensive than having a thoughtful IRA Exit Strategy over a series of tax years.

We do this type of planning at PCA, when appropriate for clients, based on their unique facts and objectives. If you are not already a PCA client, why not get better acquainted with us?  Contact our firm today.