Have you considered a Roth IRA conversion? Often times when these conversions are described, they are only presented in the most flattering light. While they can be a valuable planning tool (along with a way to perhaps save on taxes in the long-run), they aren’t the right answer for everyone.

In case you’re not familiar, a Roth IRA conversion is when you move money from a traditional IRA or 401(k) into a Roth IRA. A few years ago, Congress removed the income restrictions so now everyone has the ability to do a Roth IRA conversion – even if you can’t make contributions to a Roth IRA directly.

So, why would you want to convert money from a traditional IRA or 401(k) to a Roth IRA?

Well, there are a couple of reasons.

First, distributions from a Roth IRA are tax-free (in most cases) whereas distributions from traditional IRAs and 401(k)s are subject to ordinary income tax.

Second, Roth IRAs do not have a required minimum distribution (which means that you are not forced to take money that you may not need just because you turn 72). This allows the money to continue to grow well beyond your retirement date.

But before you say, sign me up, you need to know a few things about Roth IRA conversions.

To begin with, the transaction itself is a taxable event. If you were to convert $100,000 from an IRA to a Roth IRA, the $100,000 would be listed as ordinary income on your tax return.

This means that in addition to your other income, any Roth IRA converted amounts will be added to your tax return determine the amount of tax that you owe.

Next, you need to consider how you are going to pay those additional taxes. If you don’t have the cash, then you may think that you can just pay the taxes from the amount you are converting. While this can be done, it could be a mistake for a couple of reasons.

First, if you pay the tax from the converted amount, you don’t have that money growing tax-free. Second, if you are under 59 ½, the amount that is used to pay the taxes instead of being converted is subject to an additional 10% tax penalty for early withdrawal.

If the tax issues weren’t enough, you need to remember that the IRS has a five-year rule for Roth IRA withdrawals. This means that you must wait five years from the date of your first Roth IRA contribution or conversion before you can withdraw your earnings tax-free.

Finally, a Roth IRA conversion is not reversible. Once you convert money to a Roth IRA, it’s permanent.

One other item to consider – however unlikely. The Roth IRA was created by Congress. They made the Roth IRA tax free, and they could change the rules. None of us knows what the tax code may look like in 20 years.

So, while a Roth IRA conversion can be a smart move for many people looking to save money on taxes and gain more flexibility in retirement, it isn’t a perfect solution for everyone. It’s important to consider your tax bracket, cash flow needs, the five-year rule, and irreversible nature of the decision.

If you want to know if a Roth IRA Conversion might make sense for you, let’s get back to personal. Sit down with a financial planner who can help you consider all of the options. And if you don’t have a financial planner, I’d be happy to help.

Wozny Capital Advisors, LLC and Stratos Wealth Advisors, LLC do not provide tax or legal services and the information should not be construed as such.  This information is not intended to be a substitute for specific individualized tax advice.  We suggest that you discuss your specific tax issues with a qualified tax advisor.  Consult an attorney or tax professional regarding your specific situation.