Roth Conversions: When is Enough Enough?
In the world of personal finance and retirement planning, one strategy that has garnered significant attention in recent years is the Roth conversion. For many, it presents an opportunity for tax-free growth and potentially lower taxes in retirement. However, as with any financial strategy, there comes a point when one must ask, "when is enough enough?" In this article, we’ll explore the concept of Roth conversions, their benefits and drawbacks, and when it might be wise to halt further conversions.
Understanding Roth Conversions
A Roth conversion is the process of transferring funds from a traditional retirement account—like a traditional IRA or 401(k)—into a Roth IRA. The primary difference between these accounts lies in how they are taxed. Traditional accounts typically allow for tax-deductible contributions but tax withdrawals in retirement. In contrast, contributions to Roth accounts are made with after-tax dollars, allowing for tax-free withdrawals in retirement if certain conditions are met.
Benefits of Roth Conversions
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Tax-Free Growth: Once your funds are in a Roth IRA, they grow tax-free, allowing your investments to compound without the burden of future taxes.
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No Required Minimum Distributions (RMDs): Unlike traditional IRAs that require minimum distributions starting at age 73, Roth IRAs do not have RMDs during the account holder’s lifetime, providing more flexibility in managing withdrawals.
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Tax Diversification: Having both traditional and Roth accounts can create tax flexibility. In retirement, you can choose to withdraw from either account based on your tax situation.
- Potential for Lower Taxes: If you expect to be in a higher tax bracket in retirement, converting to a Roth while in a lower bracket could result in overall tax savings.
Drawbacks to Consider
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Immediate Tax Liability: Converting to a Roth IRA triggers a taxable event. You will owe taxes on the converted amount as if it were ordinary income, which can be substantial depending on the amount converted.
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Impact on Tax Credits and Deductions: A significant Roth conversion could push you into a higher tax bracket, possibly affecting eligibility for various tax credits and deductions.
- Loss of Tax-Deferred Growth: By converting, you forgo the tax-deferred growth on the amount moved from a traditional IRA to a Roth IRA.
When is Enough Enough?
When considering how much to convert, it’s essential to analyze both your current financial situation and your long-term goals. Here are some factors to help determine when to stop converting:
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Current Tax Rate vs. Future Tax Rate: If you anticipate being in a lower tax bracket in the years to come, it may be wise to limit conversions. However, if you project that tax rates—both currently and in the future—will increase, continuing conversions may be beneficial.
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Income Fluctuations: If you experience a year of lower income, it might be an opportune time for a larger conversion. Once your income returns to normal, consider how many conversions—if any—you wish to make moving forward.
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Strategic Tax Planning: Consider working with a tax advisor to evaluate your overall tax situation. They can provide guidance on the maximum amount to convert each year without pushing you too far into a higher tax bracket.
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Age and Retirement Timeline: Your age and expected retirement age can influence your decision. The closer you are to retirement, the less time you may have for the benefits of tax-free growth to materialize.
- Health and Legacy Goals: If you have health concerns or specific legacy goals, you might want to limit conversions to ensure enough funds are available for your desired outcomes.
Conclusion
Roth conversions can be a powerful tool for retirement planning, enabling individuals to capitalize on tax-free growth and withdrawal flexibility. However, with any financial strategy, moderation and careful consideration are key. When determining how much to convert, assess your tax situation, future income expectations, and retirement timeline. Consulting with a financial advisor can also provide clarity and aid in decision-making. Ultimately, knowing when enough is enough can ensure that your Roth conversions work harmoniously with your broader financial goals.
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I would think you’d like to get your RMD down to a low enough number that the RMD is the amount you need/want to live off in retirement (at RMD age).
Since Roth IRAs are tax-free, you get to keep more of the hard-earned money you've invested. I’m considering investing over $300k, but I’m unsure how to proceed.
Good video. Your points are valid. A couple of comments. Unless you are converting at zero tax which means the break even is immediate, it’s hard to calculate a break even without knowing what future tax rates will be, when you and your spouse will die, what the growth of your accounts will be, inflation impact to tax brackets and IRMAA surcharges and your heirs tax bracket when you die. The points about IRMAA and Cap gain harvesting cut both ways. If you are 63 or older the income from the conversion can cause an IRMAA surcharge and at any age where your income is in the 12% bracket a conversion could cause your dividends and cap gains to be taxable (if it bumps you up to the 22% bracket). On the other hand converting could avoid IRMAA surcharges when taking RMDs. You need to make some assumptions but can estimate your future tax rate.
I recently reallocated my Roth IRA to 50% SCHD, 25% SCHX, and 25% SCHG. For my Roth 401(k), I’ve set it to 70% Vanguard S&P 500 Index, 20% Vanguard Growth Index, and 10% Vanguard International Index. I’m aiming to grow my $350K portfolio to over $1M within the next three years before retirement. Open to suggestions for the best strategies to achieve this goal!
when you dont have to pay any taxes..that is enough…
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.
Amazing video, A friend of mine referred me to a financial adviser sometime ago and we got to talking about investment and money. I started investing with $150k and in the first 2 months, my portfolio was reading $274,800. Crazy right!, I decided to reinvest my profit and get more interesting. For over a year we have been working together making consistent profit just bought my second home 2 weeks ago and care for my family
I converted a lot when the stock price was way down. The profit I have made since then in my Roth more then covers what I paid in taxes.
I like the simple way a Roth IRA can be passed to your kids-Tax Free. Not only would I benefit from lower taxes during my life, but my kids will get 10 years of tax free investments from the Inherited Roth IRA which will be the high, earning years of my kids.
I'm already 65 and I have no SS (though I do have retirement money from my State ret. fund). I hate to say it but….. Paying zero tax….living at or under the "standard deduction" (and extra, if you're above a certain age).
LOL. It's not happening. Well, not for me. Besides, I have some REAL bills to pay.
OK, Ok……IF…….all of my extra wealth (read as : retirement money) was in a ROTH?
I have about 400K in a 401K plus multiple Roth IRA's. If I decide beginning converting the 401K to a Roth IRA, is there any advantage or disadvantage to doing a direct transfer to a trad IRA (to be set up)? Or should I direct any conversion amts directly into one of my long-established Roths?
I would rather pay tax now on contribution than to pay tax on contributions and growth 20yrs from now. At that point tax rates don’t matter.
I am 53 years old and consider myself to be a high earner. My job provides me the option to contribute the employer contributions to my Roth 401k. Should I do that or should I continue to direct that to my Traditional 401k ahead of retirement?
I am not against converting for the right fact pattern but some things to consider before converting that make it less attractive.
1. State taxes. Will you move to Florida or another state with zero tax during retirement?
2. Time value of money. The taxes paid today are with dollars worth more than those paid many years in the future.
3. If you don’t convert, you won’t pay the tax all in one year. In fact, some of it is likely going to be paid after you die.
On his face, you should always try to become tax-free in retirement. The idea that the federal government will not become more pernicious given the debt level is Pollyanna thinking. You can spend 30 years in retirement and the idea that your subject to taxes or even means testing based upon income scares the heck out of me and does all of my clients.
If you know you will have an inheritance, you have to plan (the best you can) for that too. It gets even trickier not knowing the age at death of the giver and receiver.
Wonderful info from Dana. Somewhat complex since it covers everything from low income to high income for conversions taking into consideration possibly having extra Medicare payments or missing some subsidies on the low income side. Dana is smart and honest in her remarks and points out doing too much in conversions might not be smart. There is a lot of bad analysis on YouTube so she is very refreshing. Comments from reviewers seem like they are more knowledgeable about finance / math which is a good sign. My situation has been somewhat simple but I would totally trust Dana if it was more complex.
I am a huge fan of the Roth IRA like Dana. I think a some mix of Roth/regular makes sense starting out or 100 % if in low income. At the same tax rate during producing and withdrawing years the math is equal for both IRAs. The Roth can be huge in keeping taxes low when extra expenses occur.
My situation. Retired early. Taxed at 25 to 28% while working. Did Roth conversions mostly at 12 and 15% during last 15 of 20 years (4 more years to go). Lended 40k to family trust (10 years ago from Roth )to fix house before sale. Bought a car recently and used another 25k of Roth. Extra expense from my rectal cancer last year ( I am good now I think). Roth is huge in helping stabilize tax rates. Before doing these conversions I am sure we would be in the 22% bracket if either of us died. Also, conversions are cheaper in Vegas with no state taxes on the Roth. When we die our family will get tax free Roth’s when we paid 12 to 15 percent and they would pay a huge amount since distributions would be in addition to their current income.
Big Smiles and thanks Dana,
Gary
All these folks do not own brokerage accounts and CDs? What about taxable short/long term capital gains, dividends, interests, royalties, rental income, pensions, and social security creating retirement income?
My understandings is If you are over 59 1/2 and convert a TRADITIONAL IRA to ROTH IRA. You can draw on the principle only and need to wait 5 years to draw on any proifit. So for example, I deposited 10k into a ROTH and the account went to 15k inside 5 years after my deposit. I can draw the 10k but will be unable to draw on the 5k profit until 5 years after the ROTH conversion?
—Once taxes are paid that money is long gone, goodbye with no opportunity for further investment growth. The idea that a person should covert their entire traditional 401K to a Roth 401k and thus pay all of those upfront taxes presumes that during their retirement years they will draw down their entire traditional 401k and thus would have to pay taxes on the back end on all of their tax deferred contributions and investment gains.
—-Only if a person draws down their entire traditional 401k during their remaining life will they be paying taxes on all of their tax deferred contributions and investment gains. Normally, they will not draw it down entirely but will leave some portion (perhaps a considerable portion) of their 401K to their heirs. That portion can stay invested and continue the tax deferred growth. Thus, the retiree during their remaining life, will never pay back all of the taxes that they deferred, and their heirs, like them, will pay taxes only on the portions they draw down.
I am maxing out my Roth 401k. Yes I am not currently getting any tax savings. But my earnings and withdrawals in retirement will be tax free.
Roth IRA or Roth 401(k) can help you save on taxes in retirement. Not only are withdrawals tax-free at 59 1/2 , it won't impact the taxation of your Social Security benefit and Medicare premiums.This is an important aspect of a Roth account that most people are not aware of.
yes right now I prefer the Roth 401k! Because my effective tax rate is 19%. That is for state and federal combined.
There are tools available to model various optimization strategies, where you select what to optimize for: highest end portfolio value, least lifetime taxation, etc. You can see how each one affects SS, IRMAA, taxes paid, end value, etc.
Make it sound as complicated as possible. That way you will always need to pay someone to figure it out for you.
There is a small group of retirees that should avoid Roth conversions no matter what. If you are lucky enough to have enough money to last your lifetime ( and then some) a Roth conversion is the worst thing you can do. WHy would you want to pay taxes on assets that will pass tax free when you do?
I think all these formulas tend to fail to consider when do I have the cadh flow. When is it most affordable for me to take the tax hit. I feel paying more while I have a good paying job is the time to take the hit