Converting one’s traditional individual retirement account (IRA) into a Roth IRA is not a new occurrence. Investors tend to jump ship having been attracted by the prospect of tax-free withdrawals from a Roth IRA during their retirement years. Though there are quite a few benefits associated with this conversion, it may not be the best option for you, especially if you’ve managed to save a good retirement corpus for your golden years. At the time of converting a traditional IRA into a Roth IRA, a tax is levied upon the investor that may sometimes push the investor to a higher tax bracket. Thus, one needs to be sure of their decision when it comes to making a Roth conversion.
Let’s discuss some of the cons related to a Roth IRA conversion:
1. Higher taxation:
You have to consider the big picture when going for a Roth IRA conversion. Tax-free withdrawals are one of the key features of a Roth IRA which attract an investor. However, you need to take into account that you need to pay taxes for the first five years after you convert a traditional IRA to a Roth IRA before you are allowed to make a tax-free withdrawal from your Roth account. Say, for instance, you have managed to save $100,000 in your traditional IRA and are planning to convert that into a Roth account. You would most likely fall under the 24 percent tax bracket, i.e., you would have to pay a tax amount of $24,000. If your savings are higher than this, you would fall under a higher tax bracket, thereby increasing the amount of tax that you are liable to pay.
Further, there is a good amount of uncertainty associated with the tax bracket that you may ultimately fall into when opting for a Roth conversion. You may end up being in a higher tax bracket when you could have otherwise been in a lower tax bracket if you had stuck with a traditional IRA. The major drawback here is that you may not be entirely sure which tax bracket you’ll fall into, making the conversion a calculated guess at best that may or may not be the right decision for your retirement plan.
2. Inability to make high-return investments
If you convert your traditional IRA to a Roth IRA, there may be a possibility that you miss out on investing in favorable opportunities such as stocks, mutual funds, etc. Once you deposit your money into a Roth account, though it falls under the no tax deduction slab, you are also not able to generate any returns over that money. This may seem like a good idea initially since no taxes are levied; however, with the onset of inflation, the bare minimum cash savings may not seem like a lot of money.
This situation can have a lasting effect on your finances. Since you may not be able to generate more wealth for yourself, your money may not grow. Additionally, you could miss out on recovering your deductions made at the time of converting your IRA due to the taxes paid at the time of conversion. The chance that you may recover your lost money reduces further when you near your retirement.
3. Inability to monitor withdrawals
Having the ability to make tax-free withdrawals can both be a blessing and a curse. In a traditional IRA account, there are restrictions placed on the withdrawals that can be made during the retirement period. On each withdrawal made by a retiree, taxes are levied which forces people to be careful when taking money out of their traditional IRAs. However, these restrictions are not present when it comes to a Roth IRA, which allows individuals to make as many withdrawals as they like. It can be a blessing in certain cases, as you can withdraw your funds when facing an emergency; however, the practice does have the drawback of quickly depleting your assets if you are not cautious about it.
Moreover, if you exhaust your assets, you can invite stress, particularly in instances when you do not have an alternative source of income to replenish your Roth IRA funds. You need to be careful about your savings to ensure that your assets are spread over your retirement equitably and invested in a diversified portfolio to be able to continuously create wealth.
Further, it must be noted that a 10 percent tax penalty is levied on withdrawals in a traditional IRA. This tax is over and above the normal income tax that you will be liable to pay; whereas, in a Roth IRA, no such tax penalty is levied on withdrawals. Letting your funds grow uninterrupted can help you harness the power of compounding but only if you do not make substantial withdrawals. However, knowing that you will not be charged tax when making withdrawals may lead you to become complacent with your funds and delete your savings without exercising proper caution.
Thus, Roth IRA savings may be more beneficial for investors who can exercise discipline and for those who do not touch their savings until they genuinely need the funds for a financial or medical emergency.
To summarize
As is the case with most financial products, Roth IRAs have both pros and cons. The cons related to a Roth IRA however can be detrimental for your future retirement, and in some cases may even lead to a reduction in your assets. Moreover, the entire process of converting your traditional IRA to a Roth IRA can be stressful, as it involves you taking calculated risks which ideally should be done after gathering full information.
So, if you are thinking about converting your traditional IRA into a Roth IRA, it might be helpful for you to seek professional guidance from a financial advisor to help clear any doubts that you may have about the Roth IRA conversion.