Image Credit | Gajus | Adobe Stock
As the year draws to a close, we’re finalizing Roth conversions for many of our clients, taking their income and tax situation into account. We sent out a value-add piece in October to assist with the decision of whether to do a conversion and how much to convert. [To see a sample of this letter, send an email to AAA@AndrewsLLC.com with the subject line “Sample”.]
In the past I’ve talked about the benefits of converting pre-tax IRA assets to Roth [Should You Do a Roth Conversion? 3 Major Benefits]. Today I’ll cover another part of that discussion - when should you not do a Roth conversion? It’s a decision that requires a nuanced understanding of your personal situation so consult with your own advisor before taking action.
In this post, you’ll learn:
The three situations where I don’t recommend a Roth conversion.
The hidden cost and additional taxes incurred by converting that many people overlook.
Three Situations I Don’t Recommend Roth
When should you not convert to Roth? The answer is not simple and could change from year to year.
Your conversion strategy should be assessed every year because life changes all the time. Your income can fluctuate unexpectedly, life events can occur that re-align your goals, and tax rates that are set “indefinitely” may change in the future.
When I’m discussing Roth conversions with a client, there are three situations that give me pause in recommending a conversion to them. That doesn’t mean we’ll never convert to Roth again in the future, but maybe not right now.
Starting with number 1:
They are going to deplete their pre-tax IRA assets during their retirement years.
Typically, I won’t recommend a Roth conversion to a retiree who projects to need all their pre-tax IRA assets for spending during their retirement years. Roth conversions are most beneficial when the converted assets are given time to grow tax-free in Roth. That’s the reason why they’re extremely helpful when done as part of legacy planning, where the time horizon for the investment extends to the next generation.
If a retirement plan assumes significant withdrawals from an IRA to satisfy cash flow needs, I tend to see the following:
a. The tax situation is manageable and the retiree may be in a relatively low tax bracket.
b. The required minimum distributions from the IRA will be needed for spending anyway.
c. They may not have enough liquid cash in a savings or brokerage account to pay for the taxes from a large Roth conversion.
Each person’s situation is unique based on their spending needs, but I find that retirees with less than $1 million saved for retirement tend to rely heavier on IRA withdrawals to meet their income needs. Roth conversions are less advantageous in this situation and generally we’d prefer to keep more of the money growing in the account instead of pre-paying the tax bill.
2. They intend to leave a significant amount of their money to charity or will do Qualified
Charitable Distributions (QCD) to satisfy RMDs.
The second situation I don’t recommend Roth conversions are when retirees plan to give a significant amount of their wealth to charity. If a charitable institution receives the funds, there is no tax bill owed by the donor or the charity. This is why it’s important to get clear on your financial goals before taking action. If you convert a lot of assets to Roth and pay the income taxes, only to leave most of it to charity, that’s an inefficient tax strategy.
Here's an example:
Tom and Clara are married with no kids and no living relatives to leave their fortune to. They love dogs and have two fur-babies: Mochi the Maltese and Dotty the Dalmatian. When Tom and Clara die, they want to gift most of their estate to their favorite charity whose mission is fostering and finding forever homes for rescued dogs.
Image Credit | Eric Isselee | Adobe Stock
Should they do Roth conversions over their lifetime? Maybe, if avoiding the tax torpedo is a consideration [Tomorrow's Tax Problem]. From a legacy-building perspective, however, their goal of leaving their money to charity conflicts with the need to do significant Roth conversions now.
For retirees who want to give to charity during their lifetime, Qualified Charitable Distributions can satisfy RMDs and provide a tax benefit. One of the benefits of doing a Roth conversion is lowering the amount of future RMDs - if a retiree elects to accomplish charitable giving by doing QCDs, there may not be a need to do Roth conversions. Two birds with one stone – the QCDs provide a tax advantage for giving to charity and satisfy the RMD for the year.
Image Credit | Lightfield Studios | Adobe Stock
3. They plan to be in a lower tax bracket in the future / income is higher than normal this year.
The third situation involves one of the first questions we ask when deciding whether to do a Roth conversion: how does their tax rate in the current year compare to their projected future tax rate? If their tax rate is going to be higher in the future because of additional income sources such as starting Social Security benefits and RMDs, then it makes sense to convert to Roth and pay taxes in the present. Sometimes tax rates just go up! With the unpredictability of tax laws, it can be difficult to foresee what direction tax rates are headed. When I ask people their guess as to which direction tax rates are going in the future, up👍 or down 👎, most people give the thumbs up👍.
On the other hand, if your tax rate projects to be lower in the future, it makes sense to continue deferring the tax liability until those low tax rate years. This is the case for many pre-retirees who are still working. During the years leading up to retirement, their income may be at its peak and place them in a high tax bracket. Upon retirement and the end of working income, their tax rate may be much lower.
In addition, there are years when income is higher than usual. This may be due to realized gains from the sale of property, a business, or appreciated stock. This increase in taxable income may only persist for one year before income levels return to normal at a lower tax rate. In this case, doing a Roth conversion and paying taxes at the temporarily higher tax rate may not be beneficial and one should wait until income returns to normal.
Additional Taxes to Consider With a Roth Conversion
Besides the tax liability due in the year of conversion, there are other tax considerations to know before deciding to convert.
Image Credit | leekris | Adobe Stock
First, most people know that the conversion amount is considered ordinary income in the year of conversion. What else do retirees need to know about the total impact on their tax bill before deciding how much to convert? The conversion adds to your Adjusted Gross Income and can affect or trigger the following:
Net Investment Income Tax: additional 3.8% tax levied on the lesser of net investment income or excess of MAGI over the threshold.
Additional Medicare premium (IRMAA): increased Medicare Part B & Part D premiums based on income from two years prior. Income in 2025 exceeding the
threshold will result in higher Medicare premiums in 2027.
More of your Social Security benefits being taxed: The amount of your benefits subject to federal income tax could increase based on your level of income.
Phaseout of the Enhanced Senior Deduction: new in 2025, the enhanced senior tax deduction goes through a phaseout once income exceeds the threshold.
Capital gains tax rates: Your capital gains tax rate is based on taxable income. A
conversion could push you into a higher capital gains tax bracket.
This is not a comprehensive list, but the point is that pulling one lever in your tax strategy could affect multiple areas. If you know what those areas are ahead of time, you’ll be well equipped to handle the results.
In Summary
Remember that you still have time to do a Roth conversion if you want to get it done in 2025, but the final weeks of the year will pass by quickly. Ask yourself if the three situations I described apply to you and decide if a conversion is necessary. If not this year, you can try again next year. If your financial strategy involves Roth conversion decisions, then you are in the tax-optimization level of wealth management and are likely in a very good place.
Have a safe and fun-filled Thanksgiving – see you all next week.
Travis
Investment advisory services offered through Andrews Advisory Associates LLC, a registered investment advisor. This blog is not meant to give investment advice. Before investing in any advisory product please carefully read any disclosure documents, including without limitation, the firm’s Form ADVs. The information herein is provided for informational purposes only, and does not constitute an offer, solicitation or recommendation to sell or an offer to buy securities, investment products or investment advisory services. Nothing contained herein constitutes financial, legal, tax, or other advice. These opinions may not fit your financial status, risk and return profile or preferences. Investment recommendations may change, and readers are urged to check with their investment adviser before making any investment decisions.
Comments