I Have $1.6M Pre-Tax. This Is Why You Should NOT Do A Roth Conversion (Case Study)
Roth conversions are a hot topic in personal finance. The promise of tax-free growth and withdrawals in retirement is incredibly appealing. But, as with any financial decision, it’s crucial to understand the nuances and whether it truly aligns with your specific circumstances. This case study explores why, even with a substantial $1.6 million in pre-tax retirement accounts, a Roth conversion might not be the best choice.
Disclaimer: This is a hypothetical case study for illustrative purposes only. Consult with a qualified financial advisor for personalized advice tailored to your situation.
The Scenario: John, 55, and Approaching Retirement
John is 55 years old and has diligently saved for retirement. He has $1.6 million in pre-tax retirement accounts, primarily consisting of a 401(k) and traditional IRA. He plans to retire in 5 years, at age 60, and expects to live comfortably on approximately $80,000 per year (in today’s dollars). He’s considering a Roth conversion to lock in tax-free income for retirement.
The Appeal of Roth Conversions:
Before diving into why a Roth conversion might not be the best fit for John, let’s recap the key benefits:
- Tax-Free Growth: Once funds are converted to a Roth IRA, all subsequent growth and withdrawals are tax-free in retirement.
- Tax Diversification: Having a mix of pre-tax and post-tax accounts provides flexibility in retirement and can help manage tax liabilities.
- Estate Planning: Roth IRAs can be beneficial for estate planning, as beneficiaries may be able to inherit tax-free assets.
Why a Roth Conversion Might Not Be Ideal for John:
Now, let’s examine the reasons why a full-scale Roth conversion might not be the optimal strategy for John, despite his substantial pre-tax savings:
1. The Immediate Tax Burden:
The most significant drawback of a Roth conversion is the immediate tax bill. When you convert funds from a traditional IRA or 401(k) to a Roth IRA, the converted amount is treated as taxable income in the year of the conversion.
- John’s Situation: Converting $1.6 million would add a massive amount to his taxable income. Assuming a combined federal and state tax rate of, say, 30%, John would owe a staggering $480,000 in taxes. This could significantly deplete his savings and might necessitate selling assets to cover the tax bill.
2. High Income and Marginal Tax Rates:
The benefit of a Roth conversion diminishes as your income and marginal tax rate increase. John’s income is likely in a higher tax bracket, especially with the added income from the conversion.
- John’s Situation: Converting a large sum like $1.6 million could push him into an even higher tax bracket. This could result in a disproportionately high tax bill, potentially negating the future tax benefits of the Roth IRA.
3. Potential for Lower Tax Rates in Retirement:
While tax rates are unpredictable, it’s possible that John’s effective tax rate in retirement will be lower than his current tax rate.
- John’s Situation: He plans to retire at age 60. Even without factoring in potential future tax law changes, his income will likely be lower in retirement than during his peak earning years. This could mean he pays a lower overall tax rate on his traditional retirement account distributions than he would have paid if he converted the entire amount to a Roth IRA.
4. Risk of Paying Taxes Now for Uncertain Future Savings:
By paying taxes now, John is essentially betting that his investments will grow significantly enough in the Roth IRA to outweigh the initial tax cost.
- John’s Situation: While investments could perform very well, there’s no guarantee. Market volatility and lower-than-expected returns could mean that the tax-free growth doesn’t compensate for the significant upfront tax burden.
5. Impact on Medicare Premiums and Social Security:
Roth conversions can increase your Modified Adjusted Gross Income (MAGI), which is used to determine eligibility for certain tax credits and deductions, as well as the amount of Medicare premiums you pay.
- John’s Situation: A large Roth conversion could potentially increase his future Medicare premiums, further eroding the potential benefits. It could also have implications for the taxation of his Social Security benefits.
Alternative Strategies for John:
Instead of a full-scale Roth conversion, John might consider these alternative strategies:
- Partial Roth Conversions: Convert smaller amounts each year, carefully managing his tax bracket. This allows for some tax diversification without triggering an enormous tax bill.
- Waiting Until Retirement: Consider Roth conversions during the early years of retirement when his income (and therefore his tax bracket) is likely to be lower.
- Focus on Tax-Efficient Investing: Optimize his investment portfolio to minimize taxes on non-retirement accounts.
- Tax Loss Harvesting: Strategically selling losing investments to offset capital gains and reduce overall tax liability.
Conclusion:
While Roth conversions can be a powerful tool for tax planning, they are not a one-size-fits-all solution. In John’s case, with a significant amount in pre-tax retirement accounts and a relatively short time horizon to retirement, the immediate tax burden and potential for lower tax rates in retirement might make a full-scale conversion less appealing.
Key Takeaway:
Always carefully consider your individual circumstances, including your current income, expected retirement income, tax rates, and investment horizon, before making any decisions about Roth conversions. Consulting with a qualified financial advisor is crucial to determine the best strategy for your specific financial goals. Don’t just jump on the Roth conversion bandwagon without a thorough understanding of the implications.
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Don't forget The five-year rule on Roth conversions requires you to wait a five-year holding period before withdrawing any converted balances, including contributions or earnings, regardless of age, penalty-free.
Does the software help determine whether, while working, to put money into roth or pretax via the employer plans?
I dislike taxes for one main reason: the government requires individuals to calculate their own taxes and imposes heavy penalties for mistakes. While I have no problem paying taxes as a US citizen, it seems strange to me that I have to do the paperwork when the government already has all the necessary information.
Roth conversions are most powerful for wealth/inheritance planning. The real impact is in the 10-year RMD-free window of post-death growth that exists for Roths and not traditional accounts. But if a person only cares about their retirement benefits during life (or if they're charitably inclined in death), Roth conversions frequently don't make sense.
If RMDs will be in excess of your needs, then you should do Roth conversions to bring them down. Excess RMDs force you to move monies from a tax deferred account to a taxable account, very tax inefficient if you live long.
The calcs are more 'complex' than stated in this video. By using non-IRA $ to pay the ROTH converted $ you also lower near and future taxes on those funds (interest dividends) thus maybe lower your marginal tax bracket in the future and possible future RMD induced marginal tax rates. Also, by lowering all forms of income, you will lower any Medicare income premiums. If you started the conversion in the last 8 years or so, you gained a lot of tax free income (I only do index funds). With the new tax bill, will get out the spreadsheet to see if now is the time to not do a conversion if the new StdDed, new calc on SocSec tax, and Medicare premiums based on income means this next year (2026 — too late for 2025 already did my conversion) I should not to do a 2026 conversion. The calcs are not 'complex' — just need to consider the half dozen or so variables — plus guess the future market and political climate (the new tax bill can be replaced by the newer tax bill nearly at any time, just like a recission).
If you are in a lower tax bracket when you are retired, you did a poor job of saving and investing over the previous 40 years,
Really liked your video. I liked your if/and/or approach espousing the conditions to convert or not convert. My former boss used to tell us ‘ plan the work, then work the plan.
Tax laws can be so complex, thanks for the video, you know when we say investing early for retirement some people don’t really wanna hear…. and my wife we are both retired and no debts. Currently living smart with our money. No longer putting blames on FED for our misfortunes. Investing lifestyle made it possible for us this early, even till now we earn weekly from the investment.
Since Obama was elected, I have heard taxes are going higher. They have not. The fear mongering about taxes is laughable. Also, rarely mentioned is Assisted Living Expenses can be deducted. My 90 year old mom pays no taxes besides a 6 figure income.
I’ve been hearing a lot about Roth IRA conversions lately, but I’m confused about whether it’s the right move for me. I’m 47, with a decent 401(k) and a modest traditional IRA. With taxes likely going up in the future, should I start converting now, or am I too late?
This video really spoke to me. Lately, investing has become such a meaningful part of our lives. My spouse and I have put in years of hard work, and we’re truly grateful for where we are now. We’ve managed to become debt-free, and our investments now help take care of our day to day needs. These days, we’re enjoying life’s simple pleasures traveling, playing a little golf, and spending quality time with our grandkids. If you’re working toward retirement, just know that with patience and a solid plan, it’s absolutely possible.
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Great video. This has been a great help to our family
You can run from taxes but eventually they will catch your money wherever it goes. Converting now to pay taxes now and allow tax free growth and kid gifts and reducing RMD.
Why don't you talk about the general population? Who has a child that's a doctor? That's kind of extreme, isn't it? Then who has a child that's a doctor in California? That's kind of a double extreme, isn't it? "It's a true story," is it or isn't it?
Financial planners fanned the Roth conversion flame a few years ago to generate business. Now I'm seeing a lot of videos like yours, which give a clearer picture and better understanding of who should and should not…Chat GPT is great for running some quick scenarios
Good information. If a couple with no kids will leave the estate to non-profits, does this negate the value of doing conversions?
Excellent information! Great job!! Thank you!
Always keep in mind, your individual financial situation determines if a RothConv is best for you. A couple with $500k in IRA is very different than one with $5M & pension/rental income. Bc the 5M couple will have to convert much higher $ yearly to make any impact, which will put them in highest tax brackets, which defeats the goal of conversion. One's age, expected lifespan, health also very important. There is a break even age when Roth starts to pay off, will you be already gone?
I’m an Academy member, 61, still working because I choose to. I have 3 kids.
Terminal Tax Rate = my estimate of THEIR tax rate when I die?
Sometime in the coming decades, tax rates WILL be higher across all brackets. It’s simple math. The US cannot grow its way out of trillions of debt, especially when they can’t even balance the budget. The debt is over $100,000 per person currently and is double that per productive, working member of the population.
Once you retire, you would be wise to not only fill up your current bracket with conversions annually, but probably the next one as well.
Increasing tax rates are the reason I rolled over my 401k to a Roth. I don’t want to be 69 paying taxes on current income on withdrawals made from my retirement account. I'm now seeking best possible areas or ways to gain wealth in today's economy.
Ari, fantastic video. I just had my annual review with my Fidelity Investments advisor and realized I am in worse shape then I thought. Going to tighten everything up for the next 5 years to put away as much money as possible. Thank you for all the educational content. You really do break things down in a very simple way so we understand. I'll be 60 in November and my husband is 62. We both have a small pension coming to us and thought we were in good shape but after our meeting with the advisor, I feel stressed because there's so much more we have to do and not a lot of time to do it. Your videos help me feel like I can get there. Again, appreciate all that you do for us. Thank you and keep them coming.
This is simple math no software needed.
How does your software compares to Income Labs?
Tax laws can be so complex, and it’s super helpful to break them down like this. Understanding how different policies can impact our finances is crucial for making informed decisions.
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