Talk About Money: Downsides to a Roth IRA conversion

Last week’s column focused on the new 2010 tax law that permits universal Roth IRA conversions and its advantages. Let’s call it the “Roth IRA conversions for all” rule. Still, that doesn’t mean this tax-planning strategy is for everyone.
Borrowing from last week’s parlance — Roth conversions will not always lead to financial nirvana. In fact, there are specific circumstances when Roth conversions can significantly damage one’s financial well-being.
While last week’s column was helpful in identifying suitable candidates for conversion, perhaps even more important is to consider the warning signs when a conversion might spell disaster. The financial media is consumed with these new rules, and I find they often oversell the benefits without adequately addressing the pitfalls.
People who are unsuitable candidates for conversion might answer yes to any of the following questions:
n Do you qualify for a “homebuyer” tax credit, or any other federal or state credit? If so, converting your traditional accounts could be disastrous, because any converted amount will increase your taxable income. That might, in turn, disqualify you for any deductions or credits you thought you were entitled to. Be careful.
n Is your college-age child seeking financial aid? Most schools exclude retirement plans from their financial aid eligibility calculations, but any income is included. As a result, the conversion will artificially increase your income and, therefore, potentially disqualify your child.
n Do you plan to retire abroad or in a state without state income taxes? Remember, conversions allow you to pay taxes now for a future tax-free income stream. That means that, in addition to federal taxes, local residents will have to pay California state income taxes on any conversion. But if those same residents later pick up and retire in a state without income taxes — say, Nevada — or move to Panama, Costa Rica or another popular retirement destination abroad, they could potentially avoid state taxes. Retirement relocation plans should be carefully considered.
n Do you have a SIMPLE IRA that was established within the past two years, a retirement account with your present employer or an inherited IRA? These types of accounts cannot be converted. SIMPLE IRAs (a type of employer-matching savings account) can be converted, but only after the two-year holding period; otherwise, you pay a 25 percent penalty. Company-sponsored retirement plans can qualify for conversion, but only if they are with past employers, and inherited IRAs are never eligible.
Of course, I could expand on additional considerations, but certain complexities go beyond the scope of this format. The main point of this exercise is to make you aware that there are many variables that need to be considered and addressed by you and your financial team before you take any action.
The questions above, along with those provided in last week’s column, should help prepare you for any conversation you have with your advisers. After all, it is a conversation worth having.
• Orion Melehan is a certified financial
planner for LMC Financial Services in Scotts Valley. Contact him at 454-8042
or or***@lm**********.com.
Securities and investment advisory services offered through SagePoint Financial Inc. member FINRA/SIPC a registered investment advisor. LMC Financial Services is not affiliated with SagePoint Financial Inc. or registered as a broker/dealer.