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Pros and Cons of IRA Conversions

Posted on | September 1, 2011 | 1 Comment

IRA conversions are basically where you change the classification of your account from an IRA classification as a Traditional Individual Retirement Account over to a Roth IRA. Back in 2010 the government changed the rules to allow investors to move over to Roth IRA’s from their Traditional IRA’s irrespective of the amount of money that they earned. Before 2010 people were only able to invest in Roth IRA’s if their MAGI (modified adjusted gross income) went below a certain level. One example was married couples whose combined income exceeded $179,000 – previously they would not have been allowed to invest in Roth IRA’s whereas now they can.

The next question of course is should they? What are the advantages of IRA conversions? The main one is the chance to pay less tax. By converting to Roth IRA’s you will probably end up paying less tax over the years than if you stay with Traditional IRA’s. Normally, people pay more tax as they get older and begin to earn more and more money. If you change over to a Roth IRA while you are still young and in a lower tax bracket you will have more money when you retire and are in the higher tax bracket. It will also be of benefit if the government puts tax rates up at a later date.

At the same time there are some negatives too. The main one is the question of how you’ll pay your taxes if you convert. As an example if people currently have $100,000 sat in Traditional IRA’s and they want to change over to Roth IRA’s they would end up having to pay taxes of $28000 for the privilege of doing so. Would you be able to pay that and would it be worth your while to do so? If you do have some savings set aside then that is the best way to convert. Another way is to take the money from the retirement fund that you intend to convert but this needs to be thought through carefully. That’s because if you have $100,ooo in your Traditional IRA and then lose $28000 of it to tax you will miss out on a great deal of interest on that money, interest which could grow to up to $140000 over the next twenty five years. That is a large sum to pay for the privilege of converting. Also, bear in mind that if taxes were to drop then your money would not be as beneficial in a Roth IRA conversion.

Ultimately, converting over to Roth can be an exceptionally useful and profitable tool towards your retirement. If taxes go up or your earnings go up then it will end up saving you a lot of money. But if you think neither of those are likely to happen then think carefully before converting.

Alex is a freelance journalist and financial blogger. He loves to write about football and jazz but spends most of his days writing about mortgages, credit cards and payday loans.

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