The Roth conversion topic has certainly dominated headlines, articles, and blog posts in 2010, but part of the story may be missing. A Roth conversion may not be the wisest financial move for some. Most of the reports regarding this conversion have touted the benefits, and little has been written about the negative affects to a Roth conversion.
Roth Conversion and College Planning
An ill-timed Roth conversion can dampen financial aid prospects for some college bound students. The most important year for the financial aid process is the year the high school student is a junior. This is the base year for most financial aid formulas. If a parent converts during this year, the conversion can be viewed as income to the parent. The parent will then be viewed as having more income available to pay for college, and, since financial aid is based on the ability to pay, the parent can be seen as having the ability to fully pay the college bill. Depending on the level of assets and the amount of the conversion, a Roth conversion may be a deal breaker to receive financial aid for your college-bound teenager.
Conversion Income and Taxes
Tax planning is similar to college planning in that more income creates negative consequences. Taxes are a moving target for most people, and an unexpectedly large tax bill due to a Roth conversion would certainly be painful. Remember when an IRA is converted the amount converted is considered as income in the year of the conversion (although spreading out this income is possible). If a conversion is accomplished the year in which the taxpayer is in a high tax bracket, the converted amount will be taxed at that high tax rate. The marginal tax rate could actually increase due to the conversion as well. I generally don’t recommend Roth conversion for taxpayers who are in a high tax bracket.
There are many calculators available that illuminate the tax savings generated by a Roth conversion, but these calculators fail to show opportunity cost lost to the tax due, which includes the cost of not having the money available for current needs. Ex. A conversion of a $100,000 IRA to a Roth will generate a $25,000 tax bill for someone in the 25% tax bracket. The opportunity cost of that $25,000 might be high. If the rationale of the conversion forces someone to eat rice and beans now so they can eat Fillet later, that rationale doesn’t fly with me. This will create financial dysfunction. This seems to be the case for younger couples. Younger couples implementing wise financial and tax strategies can leverage monies now when it is really needed. Most of the families I work with have children in private schools and college. They need money now and shouldn’t move backwards financially today to pay for their tomorrow.
Roth conversions can be a wonderful tax savings strategy, but these conversions should be carefully reviewed. By understanding the possible negative consequences, a mistake may be avoided. Just because Roth conversions are the topic de jour doesn’t make them right for everyone.