In a recent post I came across in a Facebook group, someone posted: "I'm planning on converting my seven-figure IRA to a Roth IRA over the next couple of years." This comment got me thinking
Have we gotten carried away with Roth conversions?
Roth conversions are an incredibly powerful tax strategy. When done correctly, they can save you thousands or even hundreds of thousands of dollars in taxes over the course of your lifetime. However, Roth conversions aren’t a one-size-fits-all solution. There are certain situations where the adverse side effects may outweigh the benefits.
If you're considering a Roth conversion, you need to think beyond just the tax bracket you’re in now versus the tax bracket you expect to be in later. In this post, we’ll dive deep into when a Roth conversion may not make sense and look at some of the hidden consequences that aren’t often discussed.
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Let’s start with why Roth conversions have become so popular in the first place. A Roth IRA allows your money to grow tax-free, and qualified withdrawals are completely free from federal income tax. Unlike traditional IRAs, Roth IRAs also have no required minimum distributions (RMDs), meaning you can leave your money to grow for as long as you want. This can be a huge benefit for those who don’t need to tap into their retirement savings early.
But like all financial decisions, you have to consider the big picture. There’s more to Roth conversions than just comparing your tax bracket today to your tax bracket in retirement. Let’s explore the hidden costs and potential drawbacks of Roth conversions, and when they may not be the best option for you.
One of the most overlooked aspects of Roth conversions is their impact on capital gains taxes. When you convert a traditional IRA to a Roth IRA, the amount you convert is considered taxable income for that year. This can push you into a higher income tax bracket, but it can also affect other types of income—particularly capital gains.
In the U.S., there are two types of income tax schedules: one for ordinary income and another for capital gains. Ordinary income includes things like wages, pension payments, IRA withdrawals, and, yes, Roth conversions. Capital gains, on the other hand, are the profits from selling assets like stocks, real estate, or mutual funds. Long-term capital gains (on assets held for more than a year) are taxed at a lower rate than ordinary income, with rates of 0%, 15%, or 20%, depending on your adjusted gross income (AGI).
Here’s the catch: when you do a Roth conversion, it increases your ordinary income. And because your capital gains is stacked on top of your ordinary income when determining your AGI, a Roth conversion can push your capital gains into a higher tax bracket. In other words, a conversion can trigger higher taxes not just on the converted amount, but also on your capital gains.
Consider a retired couple who is living off their investment account, creating $80,000 in long-term capital gains from the sale of investments. Because their income is below the threshold for the 0% capital gains tax rate, they pay $0 in taxes. However, if they decide to do a $100,000 Roth conversion, their total income rises to $180,000. Now, some of their capital gains income is pushed into the 15% tax bracket, and they end up owing $8,280 in taxes on what was previously untaxed income.
Note: "Taxable income" in the pictures below is after the standard deduction of $32,300 for a married couple over 65 in 2024.
The lesson here is that Roth conversions can have ripple effects on other aspects of your tax situation, and you need to account for those before making a decision.
In addition to affecting your capital gains tax rate, a Roth conversion can also trigger an extra tax known as the Net Investment Income Tax (NIIT). This 3.8% tax applies to investment income if your modified adjusted gross income (MAGI) exceeds $200,000 for single filers or $250,000 for married couples filing jointly.
Roth conversions increase your MAGI, which means that doing a large conversion could push your income over these thresholds, subjecting you to the NIIT. It’s easy to overlook this when planning a Roth conversion, but it can significantly add to your tax bill.
For example, let’s say you’re a married couple with an income of $240,000 from wages and investment income. If you do a $50,000 Roth conversion, your income rises to $290,000, triggering the 3.8% NIIT on your investment income. This tax would apply to any investment income above the $250,000 threshold, increasing your total tax liability.
One of the most significant factors in determining whether a Roth conversion is beneficial is how you pay the taxes on the converted amount. Ideally, you want to pay the taxes from another source—such as a bank account or brokerage account—rather than having them withheld from the conversion itself.
Why? Because if you pay the taxes from the conversion, less money ends up in your Roth IRA, and that reduces the tax-free growth potential.
Let’s say you convert $100,000 from a traditional IRA to a Roth IRA and are in the 24% tax bracket. If you withhold the taxes from the converted amount, only $76,000 goes into the Roth IRA, and you pay $24,000 in taxes. Assuming the Roth IRA grows at an average annual rate of 7% over the next 15 years, that $76,000 will grow to about $209,000.
But if you pay the $24,000 in taxes from another source and allow the full $100,000 to go into the Roth IRA, it would grow to around $275,000 in the same period. That’s a significant difference, and it highlights why paying the taxes out of pocket can often be the better choice—assuming you have the resources to do so.
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Roth conversions can also affect your Medicare premiums, thanks to something called IRMAA—Income-Related Monthly Adjustment Amounts. Medicare Part B and Part D premiums are based on your MAGI, and if your income exceeds certain thresholds, you’ll pay higher premiums.
The key thing to remember here is that Medicare uses a two-year look-back period. So, if you do a Roth conversion today, it could raise your Medicare premiums two years from now.
If your MAGI exceeds $194,000 as a married couple (or $97,000 for single filers), you’ll pay higher Medicare premiums. While the initial IRMAA surcharge may be relatively small—an extra $800 or so per year—it can quickly escalate as your income rises.
For instance, a large Roth conversion could push you into a higher premium bracket, where you pay several thousand dollars more per year for Medicare. This can wipe out a significant portion of the tax savings you hoped to achieve with the conversion.
If you’re planning to retire early and buy health insurance through the Affordable Care Act (ACA) marketplace, Roth conversions can affect your eligibility for premium tax credits. These credits reduce the cost of your health insurance premiums, and they’re based on your income.
To qualify for these subsidies, your income needs to be between 100% and 400% of the federal poverty level. However, if you do a Roth conversion that pushes your income above the threshold, you could lose those subsidies, making your health insurance significantly more expensive.
In some cases, the value of the premium tax credits you lose could outweigh the tax savings from a Roth conversion. This is especially true if you’re in your 50s or early 60s and won’t qualify for Medicare for several more years.
A key factor in deciding whether to do a Roth conversion is your expected tax bracket in retirement. If you’re currently in a high tax bracket—say, 32%—but expect to be in a lower bracket in retirement, it may not make sense to convert now.
If you’re in the 32% tax bracket today, converting $100,000 to a Roth means paying $32,000 in taxes. But if you expect to be in the 24% tax bracket in retirement, you could withdraw that same $100,000 and only pay $24,000 in taxes—an $8,000 savings. In this case, it would likely make more sense to wait and withdraw from the IRA in retirement rather than converting it now.
The same applies for money that you plan to pass to heirs - consider what their tax bracket is likely to be before you do a Roth conversion, assuming the sole purpose is to save them paying the taxes. With that said, it's not always about the math. Some may want to leave a tax-free legacy to your kids or other beneficiaries no matter the cost, and there's nothing wrong with that.
Lastly, if you plan to donate money any of your retirement savings to charity, either while you're alive or after you've passed, a Roth conversion would not make sense for this purpose. Qualified charities can receive pre-tax dollars completely tax-free through qualified charitable distributions while you're alive ($105,000 per year in 2024. Must be age 70.5 & must come from an IRA), or by designating them as beneficiary on your accounts. Because of this, it wouldn't be prudent to convert money to Roth, which could ultimately result in a lower amount (due to taxes) going to your charity of choice.
Roth conversions can also affect how much of your Social Security benefits are taxed. Social Security is taxed based on your provisional income, which includes your AGI (adjusted gross income), half of your Social Security benefits, and any non-taxable interest (like municipal bond interest).
When you do a Roth conversion, it increases your AGI, which can push more of your Social Security benefits into the taxable range. This is known as the “Social Security tax torpedo,” where an extra dollar of income from a Roth conversion not only increases your tax liability on the converted amount but also causes more of your Social Security benefits to become taxable.
Let’s say you’re in a bracket where 85% of your Social Security benefits are taxable. If you do a Roth conversion, it could push more of your benefits into that taxable bracket, resulting in a higher overall tax bill. This is especially important to consider if you’re relying on Social Security as a significant part of your retirement income.
Roth conversions are a powerful tool, but they aren’t right for everyone. Before making a decision, it’s important to think about how a Roth conversion will impact your entire financial picture, not just your tax bracket.
From capital gains taxes to Medicare premiums, healthcare subsidies, and Social Security benefits, there are numerous ripple effects that can increase your overall tax liability and reduce the potential benefits of the conversion.
If you’re unsure whether a Roth conversion makes sense for your specific situation, working with a financial planner can help you avoid costly mistakes and make the most of this tax-saving strategy.
You can download a free copy of the Important Numbers 2024 worksheet that is referenced several times in this post here: www.sparkwealthadvisors.com/importantnumbers2024
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