4 Reasons NOT to Do Roth Conversions
Roth conversions have gained considerable attention as a strategy for retirement planning, primarily because they allow individuals to convert their traditional IRAs or 401(k)s into Roth accounts, which offer tax-free growth and tax-free withdrawals in retirement. While this strategy can be beneficial for many, it’s not without its drawbacks. Here are four compelling reasons why you might want to think twice before jumping into a Roth conversion.
1. Immediate Tax Liability
One of the most significant considerations in executing a Roth conversion is the immediate tax impact. When you convert a traditional IRA to a Roth IRA, the converted amount is treated as taxable income for the year. This can push you into a higher tax bracket, resulting in a substantial tax bill that can take a considerable portion of your savings. If you don’t have the cash set aside to cover the taxes, you may find yourself in a financial pinch, potentially leading to taking on debt or withdrawing funds from other retirement accounts, which can further reduce your long-term savings.
2. Future Tax Rates May Be Lower
Many people assume that tax rates will rise in the future; however, this is not guaranteed. If you expect to be in a lower tax bracket during retirement than you are now, a Roth conversion may not make sense. You might benefit more from keeping your tax-deferred accounts and paying taxes on withdrawals at potentially lower rates in retirement. Relying on assumptions about future tax rates can lead to suboptimal financial decisions, emphasizing the importance of informed predictions and long-term tax strategy.
3. Impact on Financial Aid and Medicare Premiums
A Roth conversion can affect eligibility for financial aid and might increase your Medicare premiums. Since a converted amount counts as current income, it can influence the calculation of financial aid for students. Additionally, higher reported income due to the conversion can elevate the income thresholds for Medicare premiums, resulting in increased costs during retirement. If you fall into a situation where financial aid or healthcare costs are a concern, it’s vital to assess how the immediate impact of a Roth conversion might affect your overall financial landscape.
4. Long-Term Planning Considerations
If you anticipate needing to access your retirement funds before age 59½, a Roth conversion might not be the most strategic choice. While contributions to Roth IRAs can be withdrawn without penalty, conversion amounts must meet a five-year holding requirement before they can be accessed tax-free. If you find yourself in a situation where you require liquidity soon after a conversion, you may incur unexpected taxes and penalties. In such scenarios, sticking to traditional retirement accounts may provide more flexibility and accessibility to your assets.
Conclusion
Roth conversions can offer significant benefits for tax planning and retirement savings, but they are not universally the right choice for every individual. It’s essential to weigh the immediate tax implications, consider your future tax strategy, evaluate how a conversion might affect financial aid and healthcare costs, and think about your long-term liquidity needs. Consulting with a financial advisor can help you understand the nuances and determine whether a Roth conversion aligns with your long-term financial and retirement goals.
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Was lucky enough to have a ROTH 401k option was great because it allowed me to access the principal before 59 1/2 (not the gain) so that I could retire at 53 and enjoy life while my body is in great shape. I still have a large % of my retirement in before tax so will start ROTH conversions til 63 then live poor on paper til Medicare at 65. Also putting off SSA til at least 65 after that it will be a year to year decision.
I don't think enough thought goes into the transfer of large IRAs to your heirs. So much discussion goes into converting to ROTH but you may find that your heirs are in lower brackets and the extra 10yrs deferred taxes is also a benefit that can more than offset the tax burden. Whether its your Kids, Grandkids, Nieces and Nephews, they will thank you
I would also say…QCD can lower your tax burdens if you expect high RMDs. Also, if you are converting equities during a market high (bubble) you will be paying higher taxes due to higher evaluation of the equities…then if the bubble bursts, it might hurt even more – having paid taxes on higher evaluations then seeing the market value drop. But they say you can never time the market…
I'm all for paying less taxes, but if my biggest problem is the tax bill coming from large RMDs then I've won the game.
Why are Roth’s considered so good? Here is a basic scenario.
You have $100 per pay to put into a IRA or 401k. Assume your investment doubles every 10 years for 40 years.
In a traditional IRA/401K $100 goes into the plan. After 40 years, you have $800. If you are in a 20% tax bracket, you are left with $640.
In a Roth, after taxes you have only $80 to invest. After 40 years, it grows to $640. You take it out without no taxes, so you have $640. That is EXACTLY the same as the traditional one.
Now you can look at other factors. If you have no tax liability now, because of low income or credits, then do a Roth, since there is no current tax savings.
When you put the money in, you are saving taxes at your marginal rate. When you take it out, you would be paying the average rate, since some is not taxed, some at 10% and so on.
So my point is, you cannot ignore the tax you pay upfront, because that amount does not grow.
If you withdraw in retirement in an amount equal to your take home pay previously a Roth is going to cost you more.
In the video, it was referenced about having other funds to pay the taxes as if that doesn’t affect your overall finances. It does.
Sometimes using after tax (regular saving, brokerage account) to do the Roth conversion doesn’t make sense. If u live in a state that has state income tax, but doesn’t tax retirement income (Illinois is 4.95% with no retirement income taxed), you would be better off adding more (before the conversion) to your 401k during the year (no state income tax on contributions), then using some of it to pay the federal income tax on the Roth conversion. You essentially save 5% tax.
I did one Roth conversion at age 70, just before RMDs started. Now that RMDs are adding income tax, Roth conversions don’t appear attractive. I recommend doing Roth conversions before the RMDs start.
I knew a guy that converted from Islam to Roth. They took out a fatwa on him.
Your math is off. If you don’t put the $10,000 in your 401(k) and you are in the 24% bracket then you are really only going to have $7600 to pay the taxes on the conversion.
Very helpful
If you have a large Ira with the prospect of large rmd’s
Having a goal of converting to a Roth seems reasonable since your are paying the taxes you will ultimately pay anyway provided you asses
Irma, capital gain rates and income tax brackets. Even if you must utilize funds from the IRA to pay the taxes. Is there a flaw to this line of reasoning