Why You Should Think Twice Before Converting to a Roth IRA

The Johnson Team

Making the right investment choices can be the difference between a comfortable retirement and an uncertain future. Converting a Traditional IRA into a Roth IRA is a popular wealth management tactic for people who expect to be in a higher tax bracket during their retirement, but is it always the right choice? Let’s take a closer look at the nuances to consider here before taking that action. 

What is a Roth conversion? 

A Roth conversion is a process of moving money from a traditional IRA or 401(k) to a Roth IRA. A Traditional IRA or 401(k) is a tax-deferred account, meaning that you pay taxes on your withdrawals in retirement. A Roth IRA is a tax-free account, meaning that you pay taxes on your contributions upfront, but not on your withdrawals in retirement. A Roth conversion allows you to pay taxes on your savings now and enjoy tax-free income later. 

What are the benefits of a Roth conversion? 

A Roth conversion can be beneficial for some people, depending on their tax situation and retirement goals. Some of the potential benefits are: 

  • No RMDs: You can avoid the required minimum distributions (RMDs) that apply to traditional IRAs and 401(k)s after age 73 (age 75 for those born on or after 1/1/1960). RMDs are the minimum amount that you must withdraw from your account each year, based on your life expectancy and account balance. RMDs can increase your taxable income and push you into a higher tax bracket. Roth IRAs do not have RMDs, so you can leave your money to grow tax-free and withdraw it when you need it.
  • Lower tax liability: You can reduce your future tax liability by paying taxes at a lower rate now. If you expect your income or tax rates to be higher in retirement, you can save money by paying taxes on your savings now, rather than later. For example, if you are in the 12% tax bracket now, but expect to be in the 24% or higher tax bracket in retirement, you may be able to pay less taxes by converting to a Roth IRA now. 
  • Diversified account types: You can diversify your tax sources in retirement. Having both tax-deferred and tax-free accounts can give you more flexibility and control over your retirement income. You can choose which account to withdraw from depending on your tax situation and needs. For example, you can withdraw from your Traditional IRA or 401(k) in years when your income is low or when you have tax deductions or credits; withdraw from your Roth IRA during years when your income is high or when you have no tax breaks. 

What are the drawbacks of a Roth conversion? 

A Roth conversion is not a one-size-fits-all strategy. It can also have drawbacks and risks you should consider. Some of the potential drawbacks are: 

  • Income tax implications: You must pay taxes on the amount you convert. A Roth conversion is a taxable event, meaning you must report the amount you convert as income and pay taxes on it in the year of the conversion. This can increase your taxable income and push you into a higher tax bracket. For example, if you convert $50,000 from a Traditional IRA to a Roth IRA and you are in the 22% tax bracket, you will have to pay $11,000 in taxes on the conversion. 
  • Immediate tax liability: One important point to consider when deciding whether to convert to a Roth IRA is whether a person has other funds to pay the tax that will be due. The advantages of conversion may decrease or disappear altogether if a client pays the tax out of retirement plan or Traditional IRA funds. First, if a client is younger than age 59½, the 10% penalty tax will be imposed on the amount withdrawn from such plans. Paying the conversion tax from an existing retirement account also reduces the owner’s balance and ultimate nest egg at retirement.   
  • Withdrawal restrictions: You may lose some tax benefits or incur penalties if you withdraw early. A Roth conversion has a five-year rule, meaning that you must wait at least five years from the date of the conversion before you can withdraw the converted amount without paying a 10% penalty. In addition, if you withdraw any earnings from your Roth IRA before age 59.5, you will have to pay taxes and a 10% penalty on them, unless you qualify for an exception. Therefore, you should only convert to a Roth IRA if you are confident that you will not need the money for at least five years and preferably not until retirement. 
  • Circumstantial effectiveness: You may not benefit from a Roth conversion if your tax situation changes. An optimal Roth conversion assumes that your tax rate will be higher in retirement than it is now. However, this may not be the case for everyone. Your tax rate in retirement depends on many factors, such as your income sources, deductions, credits, exemptions, and tax laws. If your tax rate turns out to be lower in retirement than it is now, you may end up paying more taxes by converting to a Roth IRA than by keeping your money in a Traditional IRA. 

What if you estimate that you will be in the same tax bracket later?  

The general rule of thumb for when a conversion may be beneficial is if you’re in a lower income tax bracket today than you will be in when you are required to take distributions from your IRA via the IRS’ “required minimum distributions.”  

Even if you are projected to be in the same tax bracket later, a case can be made to still consider a Roth conversion.  

  • Tax rates can change. On Dec. 31, 2025, most of the changes established by The Tax Cut and Jobs Act (TCJA) are scheduled to expire, with the tax brackets reverting to 2017. For example, the same income that you receive today within the 22% Federal marginal tax bracket would be subject to the 25% bracket after the sunset date.  
  • The “widow’s penalty.” This refers to when a person’s tax filing status goes from married filing jointly to single. This chance can cause the surviving spouse to have to pay nearly double the taxes compared to what they were paying. The surviving spouse must take the same required minimum distribution from their IRAs but can be pushed into a higher tax bracket, depending on the circumstances.  
  • Maximize money for heirs. Bequeathing a Roth IRA to your beneficiary instead of a Traditional IRA has several advantages. A Roth IRA does not incur any income taxes upon withdrawal, unlike a Traditional IRA, which is taxed as ordinary income. This means that your beneficiary can receive the full value of the inherited Roth account without having to worry about tax implications. This may provide significant tax savings to your heirs and to preserve your legacy.  

How to decide if a Roth conversion is right for you? 

A Roth conversion is a complex and personal decision that requires careful planning and analysis. There is no simple formula or rule of thumb that can tell you whether a Roth conversion is right for you or not. You must weigh the pros and cons of a Roth conversion based on your current and future tax situation, retirement goals, and risk tolerance. You must also consider the impact of a Roth conversion on your cash flow, net worth, and estate planning. A Roth conversion can have significant tax consequences and implications for your retirement income and security. Therefore, it is advisable to consult a qualified tax or financial professional before making a Roth conversion to help you evaluate your options, estimate your tax liability, and optimize your distribution strategy in retirement.  

© 2024 Advisory services offered by Moneta Group Investment Advisors, LLC, (“MGIA”) an investment adviser registered with the Securities and Exchange Commission (“SEC”). MGIA is a wholly owned subsidiary of Moneta Group, LLC. Registration as an investment adviser does not imply a certain level of skill or training. The information contained herein is for informational purposes only, is not intended to be comprehensive or exclusive, and is based on materials deemed reliable, but the accuracy of which has not been verified. 

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