How To Decide Whether or Not To Do a Roth Conversion

If you are a diligent retirement saver, you've likely heard of and maybe even explored executing a Roth conversion of some of your pretax retirement savings. Now, actually doing the Roth conversion itself is the easy part, but trying to figure out whether or not it makes sense and will benefit your particular financial situation is the hard part since you will voluntarily pay taxes when you do the conversion, and the conversion can't be undone. Rather than start converting to Roth on a whim, a thorough analysis should be done before making any decisions since a Roth conversion has risk and could end up being a very expensive mistake, but when done opportunistically, it can save tens of thousands or more in taxes. So, let's take a look at how to make this decision.

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Hi. I'm Cameron Valadez, and welcome to the Retired-ish podcast. Today, we're diving into a very important and also trending topic, which is Roth conversions and the fascinating analysis of their long-term value. So whether you're someone nearing retirement, you are retired-ish, or currently in retirement, understanding how Roth conversions can impact your financial future is crucial.

If you're seriously considering implementing Roth conversions, it is not enough to simply know what they are in general terms. You have to dive a bit deeper to really understand whether or not the juice is worth the squeeze. And if you're not too familiar with Roth conversions, great. You're about to get going on the right foot. And in addition, we have previous episodes where we talk about some of the basics of Roth conversions, and we will be sure to include a link in today's show notes so you can go back and listen to those episodes. So, without further ado, let's unpack this together and see how to make sense of a potential Roth conversion.

To get straight to the point, whether or not to convert pretax money in a traditional IRA, pretax 401(k), or some other similar employer-sponsored account to a Roth depends on the difference between your tax rate when you do the conversion or series of conversions and the future tax rates when you would be distributing the money or withdrawing it. If your particular tax rate in the future will be higher, a conversion today would likely make sense and save you money.

This is a pretty simple concept. But like most things in the realm of taxes and financial planning, it's definitely not easy. That's because your future financial situation is foggy. Your puzzle isn't done yet, and we don't have a crystal ball. There are many factors at play here that can determine what your future tax rates might be. Some of that can be planned for, and some of it can't. For example, you may have a good idea of where your retirement income will come from, such as your spouse's pension income, both of your Social Security benefits and some withdrawals from retirement accounts. Therefore, you may have an idea of where you may sit on the tax tables or within the tax brackets.

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The issue is those are today's tax tables. Future tax law is unknowable and frequently changes. You also don't know how many times it will change over the rest of your lifetime and the scope of those changes. Your tax rates can also change since the tax brackets themselves will be affected by inflation over time, and the actual returns on your investments in these pretax accounts will change the minimum amount you must withdraw and, therefore, pay taxes on when you get into your seventies and required minimum distributions kick in. All of this is, of course, unknowable. Add in a potential inheritance for you or your spouse or maybe a divorce, and now we've got some serious contingency planning to do here. So, in order to avoid doing Roth conversions prematurely and accidentally handing the tax authorities too much money, these uncertainties have to be included in the decision-making process. If you don't plan well enough, a Roth conversion can end up being a very negligible payoff or even a substantial costly move.

Before we get into the meat of this, let's recap. What is a Roth conversion, and what are the typical reasons people or their professional advisors do them? Well, a typical Roth conversion involves transferring pretax money from a traditional IRA or 401(k) or the like into a Roth IRA or Roth 401(k). When you convert, you will pay income tax only on the money that you transfer, which doesn't have to be the entire account. You can do a Roth conversion of any amount that you'd like, and it is taxable in the calendar year that you convert it and transfer that money. And the main benefit to doing this is that once it's in the Roth account, it can grow tax and penalty-free provided you meet a few basic rules. This means that when you withdraw the funds in retirement, you won't owe taxes on that money, not the money converted, since you'll have already paid taxes on that previously or any of the earnings or growth of the account. But it's not all sunshine and rainbows. One of the main points to consider is the potential tax burden that you'll be incurring during the conversion process.

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Said differently, when converting, you are voluntarily paying taxes today based on the value of your investments, wagering that the tax rates that would have been applied later in your retirement years when you would have taken the money out of the account would have been more. And I just want to clarify that when I say retirement years, that doesn't necessarily mean that you actually have to be retired in the traditional sense in order to withdraw the money in your Roth tax-free. In fact, many people nowadays don't fully retire in the traditional sense without some sort of maybe part-time work, managing rental properties, which is a business, or maintaining some other kind of business.

In either case, having a nice nest egg in a Roth IRA is a very powerful tool. And as I mentioned previously, a Roth account has a couple of rules in order to get the money out tax and penalty-free. One of which, which is kind of the main rule here, is being over age fifty-nine and a half, which is around the phase of life where many people try and work less and spend more time enjoying the other great aspects of life. In this context, I'll continue to refer to that as your retirement years. And by the way, if you want more info on the various rules on these Roth accounts on how to get money out, whether it's tax-free or penalty free or both, I will include some links to previous episodes and some blog articles and flowcharts in the episode show notes, so be sure to check those out.

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Why would we consider a Roth conversion to begin with? Well, if Roth conversions are done at opportune times, you may be able to save a significant amount of money in taxes over a lifetime. That might be through taking advantage of lower tax brackets and rates or by reducing or even eliminating required minimum distributions either at age 73 or 75, depending on your date of birth. And those come from your pre-tax retirement accounts, which currently seem to be the most sought out and popular reason for doing Roth conversions. Again, that is to reduce those RMDs once you're in your seventies.

By reducing RMDs during your retirement years, especially if you expect to have very large pretax account balances, you might also mitigate or avoid other forms of taxation, such as surcharges on your Medicare premiums known as IRMAA, reducing taxes on your Social Security benefits, potentially reducing the net investment income tax being paid if applicable to you if you have a high income, or by lowering your taxable income enough to utilize other tax deductions, such as certain itemized deductions or even being able to use losses from some of your passive real estate, that you might have or rental properties. Some other key reasons to consider doing a conversion might be to try and reduce the tax bill for a surviving spouse if you think there's a good chance or have reason to believe that you will predecease them. And this is because, after your passing, they will be filing single and will have more compressed tax brackets and rates, which can result in higher taxation, which then reduces the amount of your hard earned savings that they will get. Another reason is to maximize the financial legacy you leave to heirs or your beneficiaries.

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If you know that you won't be spending all of your retirement assets and your heirs might be in peak earning years when they are to inherit that money, and they might be subject to higher tax rates than you. And so maybe you want to try to minimize the amount that goes to the IRS and the state tax authorities by converting before they inherit the money. And you might find it opportunistic when there is a significant drop in your pretax investment portfolio due to some sort of exogenous market event. And so you want to execute a smaller Roth conversion while the value is lower and aim to capture the market rebound once that money is now in a tax-free Roth account over a long time horizon.

And lastly, you might consider a conversion for estate tax purposes in order to reduce the value of your taxable estate on not only the federal level but also, and I would say more importantly, the state level. Now all states do not have an estate tax, but if your state does, that is very important. So, this can be a good move if you have identified that you and or your spouse may be subject to estate taxes now or in the future. Note that estate taxes are different from income taxes.

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And if you live in a state that has its own estate tax or, otherwise known as a death tax, keep in mind that their thresholds for when your estate and heirs would begin to owe this tax are often much, much lower than the federal thresholds.

As you can see, there can be many benefits to Roth conversions, many of which are somewhat complicated and are not clearly visible before your retirement years. This is why if you haven't paid too much attention to Roth conversions in the past or you're currently in what you think is a high tax bracket, I would still suggest you investigate what they may be able to do for you in the future.

Okay. Now that we understand what a Roth conversion is, I think it's important to have at least a basic concept of what is called net present value or NPV, and that is to help you determine whether or not to do a Roth conversion. Now, don't worry. I know net present value kinda sounds like a big technical and scary term, but I'm not gonna get too far in the weeds on this. I just wanna give you a basic understanding, and I'm even gonna give you some examples to help make sense of it.

Net present value is a somewhat technical financial metric used to evaluate the profitability of an investment. So, it helps you decide does this investment decision makes financial sense from a mathematical standpoint. In this context, it helps you compare the future value of the Roth and tax savings against the current tax bill you will pay when doing a Roth conversion or a series of smaller conversions over multiple years. Said differently, it will allow you to analyze mathematically if the benefits of potential tax free growth in your Roth account outweigh the immediate costs of converting. In making this decision, you have to make an educated guess or reasonable assumption about what your future tax rates and investment growth might be.

Here is a hypothetical example to help explain this a little bit further. If you have, say, a $20,000 portfolio in a pretax account, such as a 401(k) or IRA that is invested in stocks, and let's say it returns on average 10% a year, and your overall tax rate on withdrawals today would be 25%, and you convert the entire account today, tax of $5,000 will be due, which is our $20,000 portfolio times the 25% tax rate, again, because we would be converting the entire amount today. If, instead, the entire account is withdrawn after one year of appreciation at 10%, then $22,000 will be withdrawn, and the tax due will be $5,500. So there's an extra $500 of tax because our account is $2,000 larger, and again, we are still paying that 25% tax rate.

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So 22,000 times 25% gives us that $5,500. Now, if we discount that at the portfolio's rate of assumed appreciation, which is that 10%, then paying $5,500 after one year is no different from paying $5,000 today. And some might think of this concept as the time value of money. Now, it's important because if you don't account for the net present value, then a Roth conversion of any amount will look like it always makes financial sense. And you may be fooled into making a decision to convert when it may not actually make sense for your situation. For example, if that same $20,000 were to stay invested, averaging a 10% rate of return for thirty years, then the value at that time would be nearly $350,000, and the taxes due at 25% at that time would be around $87,250. You may think, wow. Why wouldn't I pay $5,000 today rather than $87,000 in the future? Well, the answer is you would every day of the week, but that's not accurate in this case because there was no discounting accounted for.

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We did not account for net present value. You can see how easy it is here to get tripped up. And because of this discounting, the time it takes to recoup your cost to convert, AKA the taxes paid to convert or the payoff, we will call it, that can vary depending upon the exact conversion scenario and when the money is ultimately distributed. This is because a dollar received well into the future is not worth the same as a dollar paid to the government today.

For example, in a bit more layman's terms, if you do a $100,000 Roth conversion to, let's say, reduce your future RMDs, and you're in the 22% federal tax bracket today, and you expect to be in, let's say, a 25% tax bracket in the future, the conversion will cost you $22,000 today, which is the $100,000 Roth conversion times your current tax rate of 22%. The effect of that conversion is that it will reduce your RMDs in the future and, therefore, reduce the amount of taxes paid at that time as well. However, because the required distributions are a relatively small percentage of the account value each year and the difference in tax rates is small in this scenario, again, it was 25% versus 22%, the tax savings each year will also be fairly minimal. In a scenario like this, it can be as little as a hundred dollars a year.

No need for you to do any math here. Recouping the tax savings in a scenario similar to this is going to take decades, and it's more likely that your heirs will be the ones to benefit from it. You may not see a dime of savings during your own lifetime. However, this isn't necessarily a bad thing at all if that is your goal for the conversion to begin with. Maybe you're doing it because you know you're not gonna spend everything, and you want to leave your heirs money in the most tax-efficient manner. That's completely okay. But if benefiting your heirs isn't the goal, you have to be careful about when and why you're doing a Roth conversion. It may seem like a fantastic idea, but it doesn't always make intuitive sense.

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Here's an easier way to think about the net present value or discounting in this particular situation. Doing conversions at lower tax rates to reduce RMDs in the future can definitely pay off. However, it may take a long time if you are only recouping a small part of the tax savings each year that goes by. Meaning there may need to be a long time horizon to actually pocket the savings. And I will say that there are situations that can happen throughout your life that can speed up this payoff, but that's getting a little too into the weeds for this discussion, and some of it relies on a bit of luck. In many cases, it may only truly benefit your beneficiaries, and you may not actually see any of the savings during your own lifetime. This, again, will depend on the exact scenario when the conversion or conversions took place, your future tax situation, and how big any difference in tax rates is. That being said, the conversions that have the fastest payoff are those that are done when there is a more advantageous difference in tax rates.

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Again, for example, if you expect to be in the 22% or higher tax bracket for years to come, but you have a one-off year this year where you know you will be in the 10 to 12% tax bracket for whatever reason, and you do a Roth conversion, that will pay off much faster than if the difference in tax rates was much smaller, like 2 to 3%, such as in my RMD example before where we had 22% versus 25%, only a 3% difference. So when doing your analysis, the primary question then becomes, do you know how many years it will take to receive the payoff from doing a lump sum Roth conversion or series of conversions?

Now, let's take a look at some examples of when a Roth conversion might actually hurt you. There are generally two different scenarios where a conversion that once looked like a good idea can actually end up costing you a lot of money. The first is if there are unanticipated changes in future tax law that lower your income tax rates in one way or another or they stay exactly the same as they were when you did your initial conversion. If your tax rate declines in the future, that means you would have paid more in taxes when you previously did your conversion than you could have paid at the future lower tax rates if, instead, you took the money out of the pretax account at that time.

Another example of a scenario like this may be the fact that you proceeded to do a large Roth conversion, anticipating that tax rates would be higher in the future, but they end up not changing at all during the remainder of your lifetime or between the time you did the conversion and took money out of your pretax account. In this case, your taxes didn't go up per se, but by doing a conversion, you would have just given the IRS and potentially the state a loan that may pay off very slowly over time or only years after your heirs have already inherited the money.

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Now, in my opinion, tax law staying the exact same over a, let's say, twenty to thirty-year period is highly unlikely, but I suppose it's still possible, and it's still a risk. And as far as tax rates being reduced in the future, this is also definitely possible and has happened to many people in the years past. I'd say it's even more likely than rates staying the same over a long period of time.

But in my opinion, it's still unlikely as of right now over the long run due to our nation's rate of spending and debt levels, which I'm sure you're aware of. Time will tell. As you can see, the risk with this first scenario of rates going down or staying the same is largely unknown, and it adds risk to the situation. Very careful planning needs to be done to see if it is a risk worth taking and something that fits your ultimate goals for the money.

The second unfortunate scenario is if you end up incorrectly anticipating your own financial and tax situation in the future. This is a scenario where you do have a lot of control over as opposed to the first, but you don't have all of the control. In order to get an accurate picture of what your future financial situation may look like, you will need to sit down and do some sort of financial planning. Right? This isn't just going to happen on its own. And the earlier in life you do this, the more difficult it can be since there is more time for things to change drastically. However, if doing this sort of planning near retirement, you should be able to get a fairly accurate picture. Now the tax piece of your future financial situation is the really tricky part. And while there can be many, here is just one example. Let's say you are looking at what income sources you will have in retirement, and you do a rough tax projection.

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You see that if it was today, you would pay 24% in federal taxes based on all of the income that you have coming in today. Let's also assume for this example that the tax rates stay the same and there are no legislative changes to the tax law. You also notice that your income will actually go up over time due to cost of living adjustments on your Social Security. Your required minimum distributions from your IRAs will go up as you get older, and your accounts hopefully grow, and you will continue to raise rents on your rental properties. So you decide to take your higher expected income ten years into the future and apply it to the tax tables and notice that your marginal tax rate will be 32%, which is an 8% jump from today. Therefore, you do a large Roth conversion to save a bunch of taxes. Sounds logical. The issue here is that tax brackets also inflate over time due to inflation, and depending on where exactly you land in those brackets, your tax rate ten years into the future, in this example, may still be 24% and not 32%.
So again, in this case, you may be giving the tax authorities a massive loan that takes years, if not decades, to mature, or you may simply have made a very costly mistake.

[00:25:17]:
We've covered a lot of ground, from understanding Roth conversions and net present value to evaluating different scenarios and some more technical concepts. It's essential to begin and also revisit your retirement strategy regularly given the potential advantages that Roth conversions of pretax money can do for you. However, you have to remember that a Roth conversion can carry and does carry a decent amount of risk depending on the situation. Therefore, the question, should I do a Roth conversion, does not have a black and white answer, and it will depend on an incredible number of factors. In my opinion, the lowest-risk Roth conversions are done when you are able to convert dollars at some of the lowest tax rates, and you expect to be subject to higher tax rates later. You are converting to leave a more tax-efficient legacy for a spouse or other heirs with a longer time horizon or for those who were in the highest of tax brackets while working. And when they stop working, they want to try and reduce the disastrous tax effects of large required minimum distributions that will start in their seventies. Roth accounts are arguably the best type of investment account when it comes to tax efficiency and sticking it to the man. But this can only be true if the cost of funding the Roth account over time is minimal, meaning if the taxes paid are reduced as much as possible.

[00:26:56]:
Thank you for joining me on Retired-ish. I hope you now feel more equipped to reflect on your options regarding Roth conversions and the common misconceptions, such as believing that you'll be in a lower tax bracket in retirement, which can lead to costly and irreversible decisions. And as you've learned, the reality is that tax laws and personal income can be totally unpredictable. So, if you're on the fence about a Roth conversion, consider running an analysis with a qualified professional who understands your unique circumstances. Going through conversion scenarios with someone who understands the fine nuances of Roth conversions combined with experience and using very sophisticated software can help you determine whether or not your Roth conversion payoff actually aligns with your intended goals.

If you found the topic discussed in today's show actionable, insightful, and valuable, do yourself a favor and subscribe to or follow the show on your podcast app. That way, you can get alerts each time a new episode drops. Also, be sure to check out the Retired-ish video newsletter to get more useful information on retirement planning, investments, and taxes once a month straight to your inbox. The newsletter will often dive deeper into some of the topics we discussed on the show as well as offer some useful guides and charts available for download. If you want to learn more about Roth accounts and conversions or you want to ask a question to be answered on a future episode, you can find links to the resources we have provided in the show notes right there on your podcast app, or you can head over to retiredishpodcast.com/64. Thanks again for tuning in and following along. See you next time on Retired-ish.

Disclosure [00:28:58]:
Cameron Valadez is a registered representative with, and securities and advisory services are offered through LPL Financial, a registered investment adviser, member of FINRA SIPC.

The opinions voiced in this podcast are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine what strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision.

Distributions from a conversion amount must satisfy a five-year investment period to avoid the 10% penalty. This pertains only to the conversion amount that was treated as income for tax purposes.

Contributions to a traditional IRA may be tax deductible in the contribution year with current income tax due at withdrawal.

Withdrawals prior to age 59 may result in a 10% IRS penalty tax in addition to current income tax.

A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 or prior to the account being opened for five years, whichever is later, may result in a 10% IRS penalty. Limitations and restrictions may apply.

Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA.

In addition, if you are required to take a required minimum distribution, RMD, in the year you convert, you must do so before converting to a Roth IRA.