7 Reasons NOT To Do Roth Conversions
Don't just do a wrong conversion because the cool thing to do or it's what someone else is talking about, these are powerful strategies, but they're only good in the right situation. And that's why you have to have a plan that's built for you and your unique situation. None of these things are blanket statements. None of these planning ideas or thoughts are across the board gonna work. Welcome to Retirement Answers, a podcast built to answer your most pressing retirement questions.
Jacob:If you're someone who's either thinking about retirement or already in retirement, well, you're in the right place. Hey there, my name is Jacob Duke, and each week I'll be walking through different tips and strategies to help you succeed in retirement. So let's go ahead and get started with today's show. Hey, friends, and welcome back to another episode of Retirement Answers. My name is Jacob Duke.
Jacob:I'm your host as always. This week, I wanted to talk about seven reasons that you should not be doing Roth conversions. Now, you heard me right. These are reasons that you should not do Roth conversions, not reasons that you should. And the reason that I wanted to talk about this is because Roth conversions are often a big, talking point or tax planning tool for people that are in retirement.
Jacob:And it's a valid one. It's one that can actually save you hundreds of thousands of dollars in taxes over the rest of your life. But the big if here is that only works if you are a prime candidate for Roth conversion. So what I've found as a financial advisor and someone who works with retirement age people or people planning for retirement all the time, is they actually try to do Roth conversions when they otherwise shouldn't be, or they're really not a good candidate to do so. So that's what I wanted to talk about today because I don't want you to make these mistakes by thinking you're doing something good when actually you're doing a little bit more harm than good.
Jacob:So the first reason that you shouldn't be doing a Roth conversion is simply because you don't have enough money in tax deferred accounts, such as a traditional four zero one ks or traditional IRA or a traditional four zero three b. If you don't have enough money in these accounts, then it might not be worth it to do a Roth conversion. Because remember the reason for a Roth conversion is overall to simply reduce your lifetime tax bill. So really what's happening here is we're shifting the income tax that we're gonna pay on our tax deferred assets. We're shifting that from the future to the present by deciding to pay our taxes before we otherwise have to in the future.
Jacob:So whenever you take money out of an IRA that's tax deferred or four zero one ks that's tax deferred, you're gonna be paying income taxes on those withdrawals or those distributions in the future at the time that you take that distribution. Now, if you don't take any distributions out, once you reach what's called RMD age, required minimum distribution age, you will be forced to begin taking money out over the rest of your life on a set schedule. So, what happens here is if you don't take any money out or wind down or slowly draw down your portfolio in tax deferred assets, you're gonna have this really large tax bill in the future or later years of your retirement, because you're gonna have these really large distributions that are being forced to happen. And so what a Roth conversion really is trying to do is help lower those required minimum distributions that you're gonna have in the future by taking and paying those taxes now, hopefully at a lower tax rate. So what's kind of my idea around when are you supposed to do Roth conversions based on how much you have or when you're not supposed to?
Jacob:Well, if you have anywhere between 0 and $500,000 in a tax deferred account, you might not be a good candidate for a Roth conversion. And the reason for that again, is because your required minimum distributions likely won't be so great in the future that you're gonna have a big tax issue on your hands. Now, the next range is from 500 to 1,000,000. If you have 500 to $1,000,000 in tax deferred accounts, you could be someone, depending on your other sources of income or depending on your overall retirement withdrawal or income plan, you might be someone who needs to evaluate Roth conversions and whether or not they will benefit you. Now, if you have a million dollars or more in a tax deferred account, you're probably gonna be in that, yes, we might need to be doing some Roth conversions, at least small ones, early on in what we call your gap year.
Jacob:So, once you get a million dollars or more in a tax deferred account, depending on your plan and how you are gonna take income for yourself in retirement, you could be a really good candidate for those Roth conversions. So that's kind of like the base rule of thumb. Now, don't just base your decision to do a Roth conversion on these particular brackets or thresholds in terms of your total assets, what you've got to do is factor in your total income plan, when your income will start, where it's going to come from, what age you're going to retire at. All these different things factor into how much your tax bill could be in the future on those tax deferred IRAs or 401ks. But hopefully this will be a good starting place for you.
Jacob:So that's the first reason you should not be doing a Roth conversion is simply because you might not have enough in a tax deferred account to actually warrant or justify doing that conversion in the first place. The second reason not to do a Roth conversion is you do not have any cash on hand or any after tax brokerage account assets. Now, why would this be important? Well, whenever we do a Roth conversion, we have to pay taxes on the income we just created for ourselves. And there's a couple different ways you could do that.
Jacob:You could do that by withholding the taxes from the actual distribution itself. So for example, you could take a $100,000 and convert that to your Roth. So, if you did that and you had a 15% federal tax rate and a 5% state, that would be a 20% total tax withholding. So, you would actually not have a $100,000 going into your Roth, you'd only have $80,000 because the other 20 was held back for taxes that you're gonna pay, on the conversion, which is normal income. Or the other way is you could pay the taxes using cash that you have at your bank or in your brokerage account.
Jacob:And what you could do is you can instead of having $80,000 go in out of the 100 into your Roth IRA, you can have all $100,000 go in because you're not withholding any taxes out of the conversion amount. You're gonna pay the taxes on that with cash that you have on hand. And so the importance of this is by not having cash to pay the taxes with, you're really gonna be biting into the benefit of doing the Roth conversion, at least in part. It doesn't necessarily nullify everything if you don't have the cash to pay the taxes with and you do have to do a withholding, doesn't nullify the benefit of it because you still will be reducing your future RMDs potentially. But what it does is it actually takes away some of your investment power, how much money you have invested for you in your account.
Jacob:Therefore, you will actually grow at a slower rate back to what your net worth was on paper. So your net worth really isn't changing here. It's gonna stay the same because whether or not you pay the tax from cash or pay the tax from withholding on paper, it's gonna be the same. And it really doesn't change your after tax net worth either because if you think about it, if you had a million dollars in a tax deferred you really don't have a million dollars in a tax deferred account. You get to factor in how much tax is actually included in that million dollars that you won't get to take for yourself.
Jacob:And so what you're really doing here that we have to pay attention to, is less money is gonna be working for you if you withhold the taxes from the conversion amount rather than paying the taxes with cash. So if you don't have any cash to pay the taxes with, you might wanna reevaluate doing a Roth conversion and see, is this still beneficial for me? Now, one other kind of bonus tip here for you is that if you are under 59.5, which is the earliest age that you can actually take a distribution from your tax deferred IRA without penalty, barring any other circumstances that would allow you to do that without the penalty, you would actually have to pay a 10% penalty on the amount of tax withholding if you withhold that from your conversion amount. So again, if we go back to our example of doing a $100,000 conversion and you withhold 20,000 for taxes, technically, if you're under 59.5, that $20,000, that tax portion, that is technically a distribution. Therefore, if you do that before 59.5 and make that tax withholding before that age, you will owe a 10% penalty on that tax amount of $20,000 which is now $2,000 So you're going to pay an additional $2,000 because of an early distribution penalty.
Jacob:And just remember here, the conversion itself is not an early distribution because the money is staying in an IRA. It's just going to a different type of IRA, but the tax withholding is actually leaving the IRA and going to the IRS. So that's why that is considered an early distribution. So if you're under 59.5, you would always want to do a Roth conversion and pay the taxes with cash you have on hand, rather than withholding that tax from the conversion amount. The third reason not to do a Roth conversion is, well, you're gonna have a lower tax rate in the future.
Jacob:Remember, the point of the conversion is to reduce the amount of taxes you're gonna pay on the sum of tax deferred assets you have over the rest of your life. And so if you're in a higher tax bracket now than you would be in the future, then it probably doesn't make sense to do a Roth conversion right now. And the reason that I wanted to talk about this is because a question that I really, I get a lot is gonna be, Jacob, should I do conversions before I retire? So while I'm still working, should I start doing these conversions, kind of jumpstart this tax planning opportunity? And the answer is really well, if you're in the 24% tax bracket now and you're gonna be in the 12% retirement, then absolutely not.
Jacob:You should not be doing any conversions before you retire because your current income is gonna be higher than otherwise would be in the future during retirement. So, why would you pay tax now when you can pay tax later? That's really the question here. So if your tax rate is going be lower in the future, then don't do any conversions, just take the distributions in the future. But if it will be higher in the future, that is a good opportunity to potentially do some Roth conversions.
Jacob:So really be smart about this. Don't just do this just because you've heard about it. And that's why planning is so important. So, you have to know what the future potentially holds in regards to maybe your sources of income, whether you have a pension or rental properties or social security. And also understanding how all these different things are taxed so that you know what the best route for your right now plan is gonna be, so you know what your plan might be in the future, but you also know how to make that plan better by doing certain things right now, whether it be to do a conversion or not do conversion.
Jacob:So number three, don't do conversions if your tax rate is gonna be lower in the future. The fourth reason not to do a Roth conversion is if you have a shorter life expectancy. So if you're someone who is expected like, Hey, I'm just not gonna make it to 100 or I'm not gonna make it to 95, my family history just dictates, Look, you're not gonna make it past 75, or maybe you have your own health concerns already, it might not be beneficial for you to actually do a Roth conversion. Now, I say this with a couple caveats and I'll get to those in a second, but the main thing here is when we think about a Roth IRA or converting money to a Roth, really the benefit of the money being in that Roth IRA is time. So this is why people often say, if you're young, go ahead and start your Roth IRA, add money to it, start contributing because the biggest component of that tax free growth is the amount of time that that money can be invested.
Jacob:So if you're 85 and you're trying to do a Roth conversion, the odds of that benefiting you long term is really not very great because you likely don't have that much longer to live because time is just not on your side. But if you're 55, a Roth conversion could be very beneficial because you have thirty plus potential years that you could be growing this tax free asset for yourself, or your wife, or your spouse, or your kids, or whoever in the future, and that's gonna be that much more beneficial for you. So, if you have a shorter life expectancy, or perhaps you're already a little bit older, it might not be beneficial to do a Roth conversion in the first place. Now, wanted to speak to this caveat really quickly. If you never intend to use your funds for yourself, meaning the amount that you're converting, if you never think that you're gonna have to use that for yourself, and you're planning on that being something you give to your family or your heirs down the road, it could be a good idea to still do that conversion.
Jacob:Because if you think about it, the life expectancy or the investment time horizon here is not necessarily just your life expectancy, it's now after life for you plus another ten years. So if you think you're gonna live another ten years and then you have another ten years after that, now this ten year window post death is really having to do with the SECURE Act and the distribution rules that come with that. That's really a twenty year investment time horizon, and a Roth conversion could be really beneficial for you to do it in that situation. So the caveat is, if you don't intend to use the funds yourself and they are intended for family or heirs after you pass away, it still could be a good idea to do a Roth conversion if your plan says that this is a good idea. So again, you gotta kinda all bring it back to the plan and say, should I be doing this or not?
Jacob:But number four, if you've got a shorter life expectancy, maybe you shouldn't be doing a Roth conversion. The fifth reason not to do a Roth conversion is if you're planning to leave your assets to a charity after you pass away. Now, the reason for this is because nonprofits, they receive assets tax free, meaning they don't have to pay any taxes whenever they receive the assets. So maybe you gift appreciated stock, that's a really good tax planning strategy. If you are a charitable person, you wanna give to your church or your charity or some sort of entity that you believe in, then you can give that appreciated stock, meaning they get to benefit from it, and you don't have to pay the capital gains tax on that position whenever you gift it.
Jacob:So they don't have to pay tax, nor do you. Well, same thing happens with a traditional IRA or just tax deferred benefits in general. Whenever you gift that to a charity, let's say post death, and you leave that money to them, they don't have to pay any income taxes on the amount of money that you leave to them. So regardless of what type of asset you leave, it's still gonna show up in their name, it's gonna show up the same way. So if you've got a $500,000 Roth account, a $500,000 traditional IRA, and a $500,000 brokerage account, the charity is not gonna pay any taxes on any of those assets, even though they're all in different account types.
Jacob:So how could this be applicable in practice? Well, let's say that you've got two kids and you wanna leave some money to a charity. Let's say you wanna split it up, you know, a third to each, right? But also let's say that you've got 500,000 in a taxable account, 500,000 in a Roth, and then 500,000 in a traditional IRA. The lazy thing to do would be to name each of those three beneficiaries, the two kids and the charity, as equal beneficiaries on each account type.
Jacob:The best thing to do would be to leave, let's say you leave the taxable account to one child and the Roth account to another child, and then you leave the traditional IRA to the charity. That would be the best case scenario for everyone involved, or if you wanted to split the taxable and Roth fiftyfifty, that's totally fine too. The key is, if you're going leave money to your kids, don't leave the tax deferred asset, leave that one to the charity, because the charity is not going to pay taxes on it anyway, but if you left it to your kids, they're going have to pay at least some income taxes on whatever they receive, because they're gonna have that ten year distribution rule due to the Secure Act. So thoughtful estate planning is a big part of your, Roth conversion strategies. And if you're gonna be leaving assets to a charity, at least in some part, it might be beneficial to do an analysis to say, what should I leave to my kids or heirs or family members?
Jacob:And then what should I leave to charity? And why is that most beneficial for everyone involved? So that's number five, don't do a Roth conversion if you're gonna leave at least a good chunk of your assets to a charity, find a way to reposition who's getting what, and it might not be helpful to do that Roth conversion in the first place. The sixth reason not to do a Roth conversion is if it might push you over the IRMAA surcharge bracket. So IRMAA stands for income related monthly adjustment amount.
Jacob:And these surcharges are applied to your Medicare premiums and they're added onto whatever the base premium is for that given year. So what are the brackets? What are the income brackets that we have to stay under to avoid having additional charges or additional premiums on our Medicare? Well, in 2024, the income level is 203,000. That's where the first cliff is for these IRMAA surcharges.
Jacob:So if you earn under 203,000 married filing jointly, then you are underneath the first IRMAA surcharge cliff. Now, if you're a single tax filer, it's one half of that $2.00 3, so just over 101,000. If as soon as you go over that, now here's the thing, it's a cliff, so as soon as you go 203,001 married filing jointly, you will be in that next bracket. Now here's the catch, this isn't necessarily based on your current income that given year, it's actually looking back two years ago, so two tax years ago, right now we're in 2024 at the recording of this episode. So all surcharges for IRMAA would actually be applied based on your 2022 income.
Jacob:So that's something to pay attention to. It's always two years later that you would be paying an additional amount on your Medicare premium. So, if you're wanting to avoid these IRMA surcharges, you might not be able to do the full Roth conversion or any Roth conversion at all. And here's why. Let's say you're single, let's say you have some social security, and let's say that you also have a pension that pays you $70,000 a year, and your social security is about $30,000 a year.
Jacob:Well, that's not necessarily going to push you over the income bracket for IRMAA here because of how the social security taxation actually works and the fact that not all 100% of that 30,000 will ever be taxable. And so you could have 85 to $90,000 of AGI, and then if you do any conversions, you're gonna be pushed over that income bracket. So you might can do a really small conversion, but it might not be helpful. Now, the question here really is, is it worth it to go over that IRMA surcharge bracket so that I just pay my higher Medicare premiums for one year? Is it worth it to do that to save potentially tens or hundreds of thousands of dollars in the future?
Jacob:That's really the question. And so, if your primary goal is to avoid IRMAA, then you might not be able to do a Roth conversion in that situation. But what I've found is that you have to evaluate the total benefit of going over the IRMA bracket. So, if your tax savings in the future will be much, much greater than how much you're going to pay in surcharges, you still might want to think about doing the conversions. So, be aware of this because it's something that often gets missed or flies under the radar whenever it comes to Roth conversions, and people end up with unexpected higher charges or higher premiums on their Medicare a couple years later because they did some Roth conversions and were unaware of those IRMA limits.
Jacob:So that's number six. If you want to avoid these IRMA surcharges, evaluate and see what can you convert without going over those brackets. And, that might be a reason that you are not able or don't want to do a Roth conversion. The seventh reason not to do a Roth conversion is because it's the cool thing to do. Roth conversions are a powerful tax planning tool.
Jacob:They can help you save a lot of taxes over the rest of your life, but don't just do it because you've heard about it and it's what everyone else is doing. And I've seen this quite often, actually. I see people saying, Jacob, I'm gonna do some Roth Conversions because I've heard about this, I watched it on YouTube, I heard about it on the podcast and it sounds awesome, I really wanna save these taxes. Well, just because it's what everyone else is doing does not mean it's the right thing for you. In fact, I was talking with an 85 year old couple who called me and they're like, Jacob, I'm trying to do this Roth conversion.
Jacob:I'm trying to figure out how to make this all work. It just, I can't figure it out. And they had about $800,000 total, liquid net worth to their name and they were totally fine. They're really good and well off, but they had about $250,000 left in their tax deferred IRAs, and they were obviously being 85, they were taking their RMDs. And so they came to me like dead set on doing these Roth conversions.
Jacob:I And started asking questions and prying into like, hey, why are you doing this? And kind of tell me some background here, give me some information. And we come to find out that they were trying to do Roth conversions above what their RMDs were. Now, here's the thing, their RMDs were actually how much income they needed to meet their normal living expense needs. And so they didn't need any more income beyond that, it actually met it perfectly.
Jacob:And so they were trying to do Roth conversions above however much their RMD was, because their RMD was actually already needed. And so they were trying to do this, but what I found was that the additional Roth conversion would push them into that next tax bracket. So right now the tax brackets are ten, twelve, and then 22%. So, their 12% is pretty much filled up because of their different social security and income sources and also their RMDs. But then now they're trying to do a Roth conversion to help save future taxes, but remember they're 85 years old and they would be paying at 22 as opposed to they could just take their RMDs for the rest of their life and then dwindle their tax deferred account pretty much down to nothing, but then they would have been paying that at the second tax bracket, which is that 12%, or in a couple of years it would be 15%, as opposed to paying it at 22 to do a conversion now.
Jacob:So, this is a perfect example of, why would you pay more tax now whenever your tax rate would be cheaper in the future? So, that's a perfect example of someone, you know, wanting to do the right thing. Absolutely. Not trying to be, you know, irresponsible. They're trying to do what's best, but really trying to force the issue and trying to use a Roth conversion to their advantage when they actually probably don't need to be doing any conversions at all.
Jacob:So that's number seven. Don't just do a wrong conversion because the cool thing to do, or it's what someone else is talking about, or even someone like myself was talking about. These are powerful strategies, but they're only good in the right situation. And that's why you have to have a plan that's built for you and your unique situation. None of these things are blanket statements, none of these planning ideas or thoughts are across the board going to work.
Jacob:So that's why I encourage you to build a plan for yourself. If you need help with that, I'd be happy to have a conversation around what that looks like. I do retirement planning all day, I own a retirement planning business. So if you're, interested in learning more about how I work with my clients, you can go to rivertreewealth.com. It should be linked down in the description below.
Jacob:But then also, can reach out, schedule an intro call with me, it's completely free. Happy to have a conversation with you. So, hopefully this episode of Retirement Answers was helpful for you, as we talked about seven different reasons you should not be doing Roth conversions. And if you have any questions, feel free to reach out to me via email, happy to answer them. It should also be down below.
Jacob:Other than that, I hope you have a wonderful rest of your week and we will see you again next week. Hey, it's Jacob again, and I wanted to extend a quick offer to you. If you have a question and you would like to have it answered here on the show, please email me at jacobretirementanswers dot net. And I'd love to answer that question for you right here on the show. Also, wanted to remind you that nothing discussed in today's episode is meant to be financial, legal or tax advice.
Jacob:Retirement Answers is for educational purposes only. Thanks for tuning into this week's episode. I look forward to talking with you again next week.
Creators and Guests
