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Three Reasons You May Not Want to Convert to a Roth IRA

There’s been a lot of press surrounding the concept of Roth IRA conversions, specifically in the coming 5-6 years with our historically-low income tax rate structure. Given the low tax rates presently, and the presumed increased tax rates after the expiration of the current tables after 2025, a Roth Conversion may make a lot of sense for a lot of folks these days. However, there are a few reasons why this might not be the best idea for a lot of folks. Here are three really good reasons why you probably should reconsider…

Three Reasons You May Not Want to Convert to a Roth IRA

david byrne by alterna2

    1. “Same as it ever was…” Several factors must be considered when determining if a Roth conversion makes sense for you:
      1. your conversion tax rate
      2. the amount that you withdraw from the Roth account (after conversions)
      3. the date that you begin withdrawing that amount from the Roth account

      If you would have begun taking the withdrawals on the same date (C) regardless of the account (traditional or Roth), in the same net (after tax) amount (B), and the tax rate at that time is the same as your conversion rate (A), and your investments returned the same rate – assuming your earnings would be the same either way – there is no advantage to the Roth conversion.

      In order for there to be a benefit to the conversion, one or more of the following must happen:

      • the date you begin taking distributions must be later;
      • the amount you would take as a distribution must be less (considering the tax already paid); and/or
      • the tax you pay on the distribution would have been higher than the conversion rate.

      So, if the tax rates increase as we assume they will, it can make sense, but only if your conversion rate is less than the rate you might pay in the future. For example, if you converted $100,000 in 2020, at a marginal tax rate of 32% (due to your other income), your conversion has cost 32%. If you would otherwise take distributions from your traditional IRA in smaller increments such that the marginal rate on the distributions was only 25%, you’re losing $7,000 by converting. If the future tax rate turns out to be more than the conversion tax rate (for example, 35%), then it is in your favor to convert (per the example).

    2. A downward spiral. If the value of the investments in the account actually reduce in value, or if the tax rates decline, you’ll be in a worse position if you convert to a Roth IRA.For example, if your IRA was worth $100,000 when you converted it, if your tax rate was 25% the tax cost of the conversion is $25,000. If the value of the account subsequently falls to $50,000 – now the overall rate that the conversion cost you has inflated to 33%. By the same token, if (heaven forbid) the tax rates are lower in the future, it doesn’t make any sense for you to do a Roth conversion. The more likely event is that your personal tax rate might be a lot less – especially possible if in retirement you have a pretty low-cost lifestyle with few fixed resources like a pension.
    3. The game changes. What happens to you if Congress decides that this Roth deal is just too good? Maybe they’ll start requiring distributions of the original account owner – or restrict the amount of time that your heirs can stretch payments (this one is actually pretty much a foregone conclusion)? It’s really impossible to guess what Congress might do – but given the potential cost of lost tax revenues from Roth accounts, it’s not hard to believe that the rules could be changed to have a negative impact on your converted account.

Of course, this is not an exhaustive list – just a few good reasons why you really need to think this over before you do a Roth conversion. In general, if you can convert funds from traditional IRAs to Roth IRAs at a marginal rate of 24% or less, it’s likely a good idea to do this, for at least part of your traditional IRAs.

In addition, if it is your intention to never distribute a significant portion of these retirement funds, converting to Roth can make good sense. This is especially true if there will be a very long period of time for the converted money to grow from investments. If you plan on living a long time (and don’t need the money from the IRAs), a Roth Conversion might be a good plan for you.

You must be mindful, if nearing the age for Medicare (or already participating in Medicare), is that a Roth Conversion could temporarily make you subject to an IRMAA (Income-Related Monthly Adjustment Amount) increase to your Medicare Part B and Part D premiums. These adjustments occur based on your AGI from two years previous to the current year, so a large Roth Conversion at any time during or after your 63rd year could cause IRMAA Part B & Part D increase. Also, keep in mind the additional Net Investment Income Tax that may apply if your overall AGI is greater than $250,000 for a married couple.

8 Comments

  1. JennyM says:

    Might I suggest that you evaluate Robert Young, CFP, of T. Rowe Price for a more exhaustive article evaluating these decisions? I feel like these types of articles are doing a disservice, given that most folks who are looking at Roth conversions are people of wealth, rather than lower middle class savers.

    1. jblankenship says:

      Thank you for the suggestion. There’s plenty of room on the internet for all kinds of approaches to writing.

  2. Scott says:

    Excellent points Jim! In the case where distributions from a pre-tax IRA will not be spent, another consideration is the potential tax rate of your heirs. For example, your daughter, and only heir, is the CEO of a mid-size company. She is in the the 32% tax bracket and you are in the 22% bracket. If you anticipate the entirety of your ROTH account will be passed on to your daughter, doing the conversion may increase the net legacy you leave her. In the reverse situation, conversion may be less appealing if your heir is in a very low marginal bracket.

    In addition, when estimating future tax rates, it is worthwhile for married couples to consider the impact of mortality. It is likely that one will pass before the other and the remaining spouse will have several years of single filing status. Unless income declines commensurately, this would drive up marginal tax rates. This is especially significant if one spouse is significantly healthier and/or younger.

    Thanks for all the great educational material.

    1. jblankenship says:

      Very nice insights, Scott. You’re absolutely spot-on with both the projected heir’s tax rates and the surviving spouse’s tax rates. I’ll see about incorporating that information into the article.

      Thanks as always for reaching out!

  3. Bill Cason says:

    Good article and I much appreciate your work. You mentioned the “IRMAA” impact but it seems to me that the social security “tax torpedo” impact should also be a consideration. In my case this one is not obvious until you run hypothecial taxes in the future — not an easy thing to do with any accuracy.

    1. jblankenship says:

      I agree, the tax torpedo concept can be more egregious than the IRMAA impact, but as you say, it is difficult to calculate with any accuracy.

  4. A Good Reason to Not Convert to Roth - Finance | Business News Online says:

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