When a Roth Conversion May Cost More Than It Saves
Why paying tax now is not always the best retirement strategy
Roth accounts are one of the best deals in retirement planning. You pay tax before the money goes into the account, the investments may grow tax-free, and qualified withdrawals are generally tax-free. Roth IRAs also generally have no required minimum distributions during the original owner’s lifetime.
Those are meaningful advantages, but they do not make a Roth the right choice in every situation. A Roth conversion requires a taxpayer to include previously untaxed retirement money in current taxable income. That can be valuable when today’s tax cost is lower than the tax that would otherwise be paid later. It can be expensive when the opposite is true.
The real question is not whether Roth accounts are good or bad. The question is whether paying tax today is better than paying it later.
First, Separate Three Different Roth Decisions
People often use the word “Roth” to describe three different strategies:
- Making Roth contributions instead of pre-tax contributions to a workplace retirement plan.
- Converting money from a traditional IRA or pre-tax retirement account to a Roth account.
- Using a backdoor Roth strategy when income is too high for a direct Roth IRA contribution.
Each decision has different rules and consequences. The largest immediate tax risk usually arises from a Roth conversion because the taxable portion of the conversion is added to income for that year.
When a Roth Conversion May Be a Poor Choice
1. You are paying tax at a higher rate now than you are likely to pay later
A conversion generally works best when the tax rate paid on the conversion is lower than the rate that would apply to future withdrawals. Someone in a high-earning year who expects substantially lower income in retirement may be volunteering to pay tax at an unnecessarily high rate.
The comparison should include more than the current marginal bracket. It should also consider expected retirement income, pensions, Social Security, required minimum distributions, future filing status, and the possibility of future tax-law changes.
2. The conversion pushes other income into a higher tax bracket
A Roth conversion stacks on top of a taxpayer’s other taxable income. A conversion that begins in one bracket may end in a higher one. The additional income can also affect deductions, credits, and other provisions tied to adjusted gross income.
This is why converting an entire account in one year may be less effective than making a series of smaller conversions. A multiyear plan can intentionally fill a chosen tax bracket without unnecessarily spilling into the next one.
3. The conversion increases Medicare premiums
For Medicare beneficiaries, a conversion may increase modified adjusted gross income enough to trigger or raise the income-related monthly adjustment amount, commonly called IRMAA. IRMAA can increase both Medicare Part B and Part D costs. Medicare normally uses tax-return information from two years earlier, so a conversion may affect premiums two years after the conversion year.
This does not automatically make the conversion a mistake, but the potential premium increase should be included in the cost calculation rather than discovered later.
4. More of your Social Security benefits may become taxable
The taxable portion of Social Security benefits depends partly on the recipient’s other income. Because a taxable Roth conversion increases income, it can cause more Social Security benefits to become taxable. The effective tax cost of the conversion may therefore be higher than the stated federal tax bracket suggests.
5. You must use retirement money to pay the tax
A conversion is generally more attractive when the taxpayer can pay the resulting tax from cash or investments outside the retirement account. If part of the IRA must be withheld or withdrawn to cover the tax, less money reaches the Roth and remains invested for retirement.
For taxpayers under age 59½, using converted or distributed retirement funds for the tax may also create early-distribution complications and possible penalties. Cash flow matters just as much as the theoretical long-term tax savings.
6. You expect to move to a lower-tax state
Someone living in a state with an income tax may pay state tax on a conversion today. If that person expects to retire in a state with no individual income tax, or in a state that excludes some retirement income, waiting may reduce the combined federal and state cost.
State rules vary, and future residence is not always certain. Still, state tax should be part of the analysis.
7. The retirement money is likely to go to charity
Taxpayers age 70½ or older may be able to make qualified charitable distributions directly from an IRA to an eligible charity. When properly completed, a QCD can exclude the distribution from income and may also count toward a required minimum distribution.
Converting money that is ultimately intended for charity may mean paying tax today on funds that could otherwise have been transferred to charity without being included in income. Pre-tax retirement accounts can also be tax-efficient assets to leave to charity at death, while Roth assets may be more valuable to individual beneficiaries.
8. You may need the money before the Roth rules are satisfied
Roth accounts are subject to five-year rules that are often misunderstood. The rule for determining whether Roth IRA earnings are part of a qualified distribution is different from the separate five-year rule that can apply to converted amounts withdrawn before age 59½.
Anyone who may need the converted funds soon should review the timing carefully. A conversion should not create a liquidity problem or an unexpected tax or penalty.
When a Roth Conversion Can Make Sense
A Roth conversion can still be an excellent strategy when:
- Income is temporarily low, perhaps between retirement and the start of Social Security or required minimum distributions.
- The conversion can be completed within a deliberately selected tax bracket.
- The taxpayer expects future required minimum distributions to create higher taxable income.
- The taxpayer has outside funds available to pay the conversion tax.
- The taxpayer wants more control over taxable income later in retirement.
- The Roth is intended as a long-term asset for the taxpayer or individual beneficiaries.
The best answer may also be partial rather than all-or-nothing. Maintaining a mix of pre-tax, Roth, and taxable accounts can provide flexibility when managing future tax brackets, Medicare premiums, charitable giving, and cash needs.
The Bottom Line
A Roth conversion is not automatically a tax-saving transaction. It is a decision to recognize taxable income now in exchange for potential tax benefits later. The value depends on the tax rate paid today, the tax rate avoided in the future, the time available for tax-free growth, and the conversion’s effect on the rest of the taxpayer’s return.
Before converting, taxpayers should estimate the full federal and state tax cost, consider Medicare and Social Security effects, identify how the tax will be paid, and compare a full conversion with smaller conversions over several years.
GurelCPA offers a free initial consultation to discuss whether a Roth conversion fits your overall tax and retirement strategy.
The article is meant for informational purposes only. Please contact me directly to discuss how this applies to your individual tax situation.