4 Reasons You Should NOT Do a Roth Conversion
A Roth conversion can be an attractive strategy for many investors looking to optimize their tax situation and retirement savings. However, it’s not a one-size-fits-all solution. Depending on your personal financial circumstances and future expectations, there are several compelling reasons why a Roth conversion might not be the best choice for you. Here are four reasons you should consider before making a Roth conversion.
1. Immediate Tax Implications
One of the most significant downsides of a Roth conversion is that it can lead to a hefty tax bill in the year of conversion. When you convert funds from a traditional IRA or 401(k) to a Roth account, the amount converted is treated as taxable income. If this conversion pushes you into a higher tax bracket or increases your adjusted gross income, it can have repercussions for other areas of your tax situation—such as limiting your ability to contribute to tax-advantaged accounts or increasing your Medicare premiums.
If you’re nearing retirement or have a substantial income in a particular year, it may be wise to delay a Roth conversion until your income situation stabilizes or decreases, potentially minimizing the tax burden.
2. Future Income Needs
Roth IRAs are particularly beneficial for those who do not anticipate needing access to their funds in the short term. If you think you will need to tap into your retirement savings early, converting to a Roth may not be ideal. While withdrawals from a Roth IRA are tax-free in retirement, the funds contributed to your investments will be subjected to tax in the year of the conversion. If you require those funds shortly after the conversion, you’ll face the double penalty: a current tax obligation and a potential need to withdraw the funds before they can grow tax-free.
For individuals with lower incomes, particularly those still saving for retirement or just beginning their careers, maintaining tax-deferred growth through traditional accounts can lead to greater wealth accumulation over time.
3. Uncertain Future Tax Rates
A key selling point of the Roth conversion is the assumption that current tax rates are lower than they will be in the future. While this may be true for some individuals, significant uncertainties exist regarding future tax legislation and economic conditions. If you expect your tax rate to remain the same or decrease in the future, the benefits of a Roth conversion might not materialize as you plan.
For those worried about rising taxes, a strategic approach could involve deferring taxes as long as possible through traditional accounts, allowing for more growth without the immediate tax burden. This can lead to a more favorable tax position down the road.
4. Estate Planning Considerations
If you plan to leave your retirement accounts to heirs, a Roth conversion can complicate your estate planning strategy. While Roth IRAs allow for tax-free growth and withdrawals for beneficiaries, the rules surrounding inherited accounts are complex. If your primary goal is to transfer wealth to your heirs, you may find that traditional IRAs allow for a smaller immediate tax burden, which can be beneficial when considering their tax implications on inherited assets.
Additionally, if you have significant assets that you want to leave to your beneficiaries, the balance between tax implications upon conversion and inherited taxability should be weighed carefully. In some cases, leaving funds in traditional accounts may provide more overall wealth preservation for your heirs.
Conclusion
A Roth conversion can be an advantageous strategy for some, but it’s not without its complexities. From immediate tax implications to questions about your future income needs and the uncertainties of tax rates, assessing whether a Roth conversion aligns with your unique financial situation is crucial. Consulting with a financial advisor or tax professional can help you navigate these considerations and ensure that you make the best decision for your retirement planning journey.
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If you spent years building up a traditional retirement account go ahead and retire early while starting to draw it down.
If your closer to median retirement account value with your account balance you will not be paying much in tax.
I live in California and I am in the 24% tax bracket. California state tax will be another 9% on top of that. I am trying to figure out when my break even point would be after paying 33% for a Roth conversion now and missing out on the compounded interest on the amount I convert.
Retired and age 67. . .12 % tax bracket. . .Roth Conversion for us every year for the next 5 years to minimize tax liability and large RMDs starting at age 73.
If you consider the growth, which assumes at 8% annually, is also going to be taxed at income bracket, probably converting as soon as possible if you are young. am I right?
it would be nice if someone spoke to converting the taxable portion of a solo 401k Roth to a roth ira. can it be rolled into the roth portion of the 401k?
Another reason to decide against a conversion – the 5-year rule. If you may need to withdraw Roth conversion and Roth earnings before 5 years, you could run into tax (again) and penalty on the conversion money when withdrawn. You can withdraw contributions you made from after-tax earnings at any time, but the conversions need to simmer for 5 years.
A couple of things I noticed! You used mortgage payments as an example of needing more income. True, but mortgage payments are tax deductible, so surely wouldn't push up your tax bracket?
Secondly, it matters how you pay the taxes on the Roth conversion. If you don't have enough outside IRAs, you'll have to use part of the conversion money for taxes, creating a possibly severe "headwind" on the Roth conversion growth.
James, you state that it makes sense to convert is your in a 10% bracket and if you don’t convert you’ll be in a 22% bracket. I disagree. If you take the money that you would have used to pay taxes on the conversion, and instead invest it in a long term ETF like VOO, after 10, 15, 20 years you'll have more than enough in that account funded with what would have been used to pay taxes at 10% to pay not only for the taxes on the original IRA at a now 22% rate but also to cover the taxes needed to pay for the money pulled from that account that was invested instead of paying taxes for a conversion.
Your RMDs are growing because your balance is growing by more than what you are withdrawing.
The good news is, even if you pay more taxes because of higher RMDs that you don't need, you are very unlikely to run out of money.
We started conversions up to bracket creep at age 65 when we began retirement income streams and Medicare. Why? Well when RMDs start in a couple of years it's going to push us into the next marginal tax bracket. Right now that would be a 22% marginal rate but if TCJA sunsets it could then be a 25% marginal rate. I don't know about y'all, but I don't want to pay any more taxes than I have to. We'll have around $300k converted by the time RMDs start. This means we'll have paid taxes at a 12% marginal rate on our conversion whereas a larger RMD would take us tens of thousands of dollars deeper into the 22% marginal rate. By the way, we delayed conversions until Medicare kicked in as we took advantage of ACA provisions for health insurance.
With Roth IRA, the money you are contributing has already been taxed. At any time for any reason, you can withdraw your contributions tax-free and penalty-free. Additionally, any earnings on investments can also be withdrawn tax-free and penalty-free, Not sure how much to contribute, I'm still at a crossroads deciding if to liquidate my $338k stock portfolio.
Do States like FLA's Retirement Tax Regulations come into play?
First video I have seen of yours, very grateful for the clear explanations and examples. Just subscribed.
Additional reasons not to do a Roth conversion:
5. you can't pay the tax for the conversion from current after tax accounts; in other words don't use monies being converted to pay those taxes, ideally you convert shares and don't sell and transfer;
6. if you have taken ACA health care premium credits and you can't afford to pay back the amount that the additional income from the conversion will wipe out.
May not be a good idea if you plan to leave the traditional tax-deferred account to offspring who will be in lower tax brackets.
Would LOVE to see a video that deals with inherited IRAs, and how that affects current non-inherited accounts [IRAs, Taxable, and Roths] – how should we invest in light of future large IRA inheritances? Not a video about taking them in 10 years, etc. but rather how a future inheritance should affect the non-inherited accts [how can they be best invested, withdrawal strategies/orders, how to invest that inherited IRA, knowing the ten year clock is ticking, etc.]
I just did a massive spreadsheet comparison which included indexing everything (tax brackets, social security, withdrawals, etc) for inflation. Everything starts in an IRA. In the 1st scenario, the spreadsheet takes out what is needed to live plus a healthy vig for the unexpected, and then the RMDs kick in at age 75, though the RMDs don't outspend me until age 80.
In the 2nd scenario, the spreadsheet moves everything between what was taken out & the end of the 12% tax bracket (which jumps to 22%) into a Roth. The Roth remains untouched. FYI, each scenario assumes starting age 60, start taking SS at age 62, spouse gets spousal benefit starting at age 67. Assumed average of 6% returns. (One can quibble about any of these, but these are my situation.)
What shocked me is that even though the RMDs kick in at 75:
1. The total tax paid break-even point doesn't happen until age 87.5. Wow.
2. In the first scenario, RMDs go into the 22% tax bracket starting at age 83 & continue until 98.
3. In the 2nd scenario, RMDs go into the 22% bracket starting at age 89 until 98.
4. The total taken out in the 2nd scenario was actually significantly less, primarily because RMDs were lower, even though more was taken out in early years for the Roth conversion…. But the total leftover at the end counteracts that by about the same amount. So the growth made up for the lost taxes early on.
5. At age 90, the difference in taxes was nominal, about $17,500.
6. At age 100, the difference in taxes turned out to be about $84,000.
Factor in that those $$ in the late years twenty years from now will have a lot less buying power than $$ can buy now, and this really appears to be a wash. By far, most of the tax cost comes after age 90.
The tax cost is significantly more at higher rates of return (7-8%), far less at lower rates of return (5%), but still doesn't kick the RMDs until late 70s, though that's a small problem. If I'm getting 7-8% up until that point, I'm essentially set for life.
I'm rethinking the Roth conversion strategy altogether now, gonna run some more numbers. (FYI, changing the inflation rate doesn't change anything, because the numbers are all relative.) Yes, I could lose a lot in taxes way late in life if I make 8% & live that long, God willing. But those would be good "problems" to have.
Anyway, I realize this was only one very specific situation, but it was an excellent math exercise for me. Thank you James for getting me to think about this, and solve for it. That's what makes videos & info like this so valuable.
Wow, these are so first world problems. My goals going into retirement are…1.NOT work. 2. Stay barefoot and grounded (After wearing steel toe shoes for 42 years) 3. Have enough money to feed my two dogs. Simple life.
You give me a headache !
If you don't need all the RMD can't you put some it back into a roth or another account and try to make some of the taxes back?
My favorite charity is me and mine, nonetheless we all are forcefully giving to “charity” through multiple layers of taxation whether we want to or not
There are problems when you have too much money,
There are problems when you have too little.
The government will make sure you’re not in a lower bracket in the future!
After making the contribution of my choice from an IRA account, can I still get the standard deduction?
How much maximum do they let Roth conversion ?
If you don't need the money from your IRA it is excess cash. You invest that money into a brokerage account income on both hands. sounds good to me
So if one is required to pull out more than they need because of the RMD, then why not use the excess to put it into a Roth IRA?
Thank you for the explaining in a way that's easy to comprehend. This has now made me rethink my strategy of converting Rollover to Roth
I’m currently single 64 yr old and in the 32% federal tax bracket. I plan on retiring Sept 24. Wouldn’t it make sense to initiate some level of Roth conversions, from my 401, in 2025 when my tax bracket is lowered as I plan on waiting to take SS when I’m 67-70 and I can also stall my Pension for 1 year
If anyone thinks the existing 'tax brackets' will carry forward – they're just fooling themselves. What we know is the tax cut and jobs act expires in 26.
Wouldn't it be a safe assumption that they were planning to use charity for tax deductions? If QCD's are not taxed, that means you cant claim it as deduction for charity anymore. There does not appear to be an advantage either way in tax savings. If all things equal, would rather convert to have the flexibility of doing what I want with the money it instead of having donate option only.
There was mention that RMDs take the money out of your portfolio. The only money that has to come out is the taxes on that RMD. You're going to have to pay taxes on it eventually anyway, now or later. Invest the rest in a regular brokerage account and it's still in your portfolio, just no longer tax-advantaged.
How about if you plan to game the entitlement waterfall thresholds by limiting your ordinary income in your retirement years. Our country is moving closer and close to Socialism. So why not take advantage of some of these handouts: ACA supplements, Social Security tax tiers, IRMAA, IRA deductions, savers act, tuition and student loan repayment… Besides aren't taxes a bargain right now at 22 and 24%? You know Biden will cheat with mail-in voting again and then let the Trump tax cuts expire in 2026. Thus, raising all our taxes to 26%….
Another aspect to consider is Traditional IRA is the Required Minimum Distribution whether you need/want it or not. With ROTH IRA, you do not have that. Outside entities forcing/choosing your financial decesions is never to your advantage.
Let’s just give away all the compounding we worked decades for! Just give it away, isn’t that awesome????
The thing these scammers never mention is that these Roth and personal IRA will never provide the ability to increase your standard of living in retirement. You will only ever hear is maintain your standard or enter a lower tax bracket (read: poor life, poor activities for all of retirement.) You want a better life in retirement you’d have to double fund these accounts but oh wait, you aren’t legally allowed to. Odd…
Great Video!
Regarding giving, gifting directly from a pre-tax IRA is a no brainer.
I don't think your conclusion — that if RMDs are not an issue, then it might not make sense to do ROTH conversions — is correct. At age 65, filing MFJ, if you have 1 million in IRA and your social security is equal to your standard deduction and you need another 40K for expenses, RMDs wont be an issue as you are already taking the equivalent of RMD from the IRA. Your taxable income is 40K but if the first 93K are taxed at under 12%, then you can take advantage of that by taking 93K from IRA and putting 53K in ROTH. The whole idea of IRA is to put money into it when your tax rate is high and take it out when it is low. Comments?
Love the clear examples and scenarios you use to illustrate your presentations
Another reason not to convert. We are retired, but less than 65. If we keep our qualifying income below the ACA limits the subsidy essentially pays for our health insurance. The Roth conversion counts against this, so it would cost around $20,000 if the conversion bumped us above the ACA subsidy limits.
I would recommend in that second example of taking the balance of $12,000 from your traditional account and preserving the balance of your Roth account.
–many people on youtube who push roth conversions, leave out the "5-year rule" … after you convert a traditional IRA to a Roth IRA, you have to wait 5 years before you can withdraw without a penalty? I think. something to consider, or factor in yr decision.
if you retired and you're still your mortage you have not done well in life
always do a Roth conversion, you pay no taxes!