Every week, I buy a bag of coffee from Whole Foods. Always on the search for a deal in an otherwise expensive environment, I seek out the yellow tags. Those yellow tags are simple to understand: This bag of coffee, normally $10, is on sale for $7, until next week, when it will return to $10. Typically, there are years in your life when your taxes go on sale because your income drops. This is usually the sweet spot for Roth conversions.
(Warning: This article gets a bit technical. See my article Roth Conversions: The Case for and Against Them for a primer.)
Now, imagine a scenario where Whole Foods has both red tags and yellow tags. The red tags are the opposite of the yellow ones. They denote a temporary increase in price. Think cars and eggs in 2021. In this example, that bag of coffee is $12 and will drop back to $10 next week. Most people should, and will, skip it this week. The same is true of Roth conversions. If you anticipate your tax rates will drop, why would you elect to pay taxes at today’s higher rates? Below are three possible exceptions to the rule to consider.
From just $107.88 $24.99 for Kiplinger Personal Finance
Become a smarter, better informed investor. Subscribe from just $107.88 $24.99, plus get up to 4 Special Issues
Sign up for Kiplinger’s Free Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
1. Pessimism about future tax rates.
Every insurance salesman in America will tell you why future tax rates are going to go up (and therefore you should buy permanent life insurance to hedge this risk). Their motivation aside, some of their points are tough to argue with.
The current tax code for individuals is set to expire, or “sunset” in tax jargon, on December 31, 2025. At that point, marginal rates will increase. It doesn’t necessarily mean you will pay more in total tax, but it could increase the cost of Roth conversions.
As of today, according to U.S. Treasury data, the national debt is about $35 trillion. That’s way too many zeros to write out. There are two solutions here: Raise income or reduce spending. Spending is like a zip tie. It moves in only one direction. Therefore, we likely need to find ways to increase income, which takes us to taxes. If you are pessimistic about future tax rates, a Roth conversion is a way to lock in today’s marginal rate to avoid paying more in the future.
2. Significant savings in pre-tax accounts.
You’re a good earner, which has allowed you to be a good saver. Let’s say you’re 55 and earning $250,000 per year. You have saved $2 million in pre-tax accounts. If you earn 7.2% per year between now and mandatory distributions at age 75, your retirement account balance will be approximately $8 million. Using round numbers, if you pull out 4% in your first year, your RMD will be $320,000 in year one, which probably will send your tax rate above where it is today.*
I could make the argument that you should wait until you retire to take advantage of much lower rates. However, it may make sense for you to convert just to the top of your current income tax bracket if you know that your future marginal rate will go higher.
Your financial plan should contain a tax projection. If your adviser hasn’t done this for you, ask them to. If you’d like to build your own plan, you can use this free version of our planning software.
3. Your heir’s tax rate is higher than yours.
About 10 years ago, I met with a prospective client who lived in Washington, D.C., and was in his peak earning years. He insisted on doing Roth conversions. On the surface, given that he was a few years from his rates dropping, this was a bad idea. After digging deeper, it was evident that leaving a legacy to his son was a priority. Ironically, his son was one of the early employees at Facebook and already wealthy. His son was still working and was earning beaucoup bucks as a California resident.
It's not my role to question his goals — just to help him reach them. At this point, the Roth conversion calculation shifts to his current rate vs his son’s future rate. Income tax rates in Washington are high. Income tax rates in California are higher. The client’s income was high. The son’s was much higher. The total tax bill paid today will be lower than the rate paid down the road.
There are exceptions to every rule. The rule for Roth conversions is confidence that today’s rate is lower than tomorrow’s. If you’re on the verge of retirement, your rate once your income goes away is likely to be lower. Once again, lean on your financial planner and their tax projections for you to get a sense of what current vs future rates look like for you.
* This hypothetical example is for illustrative purposes only and is not intended to be representative of actual results or any specific investment, which will fluctuate in value. Please keep in mind that it is possible to lose money by investing, and actual results will vary.
Related Content
- Roth IRA Contribution Limits for 2024
- How a Roth Conversion Can Spare You From Medicare’s IRMAA and Taxes
- Roth Conversions: Convert Everything at Once or as You Go?
- Are You Ready to ‘Rothify’ Your Retirement?
- How a Backdoor Roth IRA Works (and Its Drawbacks)
-
December Fed Meeting: Live Updates and CommentaryThe December Fed meeting is one of the last key economic events of 2025, with Wall Street closely watching what Chair Powell & Co. will do about interest rates.
-
This Is Why Investors Shouldn't Romanticize BitcoinInvestors should treat bitcoin as the high-risk asset it is. A look at the data indicates a small portfolio allocation for most investors would be the safest.
-
I'm a Federal Benefits Pro: I Answer These 2 Questions a LotMany federal employees ask about rolling a TSP into an IRA and parsing options for survivor benefits, both especially critical topics.
-
Why Investors Shouldn't Romanticize Bitcoin, From a Financial Planner
Investors should treat bitcoin as the high-risk asset it is. A look at the data indicates a small portfolio allocation for most investors would be the safest.
-
I'm a Financial Pro Focused on Federal Benefits: These Are the 2 Questions I Answer a Lot
Many federal employees ask about rolling a TSP into an IRA and parsing options for survivor benefits, both especially critical topics.
-
Private Credit Can Be a Resilient Income Strategy for a Volatile Market: A Guide for Financial AdvisersAdvisers are increasingly turning to private credit such as asset-based and real estate lending for elevated yields and protection backed by tangible assets.
-
5 RMD Mistakes That Could Cost You Big-Time: Even Seasoned Retirees Slip UpThe five biggest RMD mistakes retirees make show that tax-smart retirement planning should start well before you hit the age your first RMD is due.
-
I'm a Wealth Adviser: My 4 Guiding Principles Could Help You Plan for Retirement Whether You Have $10,000 or $10 MillionRegardless of your net worth, you deserve a detailed retirement plan backed by a solid understanding of your finances.
-
A Retirement Triple Play: These 3 Tax Breaks Could Lower Your 2026 BillGood news for older taxpayers: Standard deductions are higher, there's a temporary 'bonus deduction' for older folks, and income thresholds have been raised.
-
If You're Retired or Soon-to-Be Retired, You Won't Want to Miss Out on These 3 OBBB Tax BreaksThe OBBB offers some tax advantages that are particularly beneficial for retirees and near-retirees. But they're available for only a limited time.
-
Waiting for Retirement to Give to Charity? Here Are 3 Reasons to Do It Now, From a Financial PlannerYou could wait until retirement, but making charitable giving part of your financial plan now could be far more beneficial for you and the causes you support.
