Roth IRAs are a hot topic these days. I get multiple media inquiries every week regarding the pros and cons of Roth conversions. But while they can be a great proposition for some people, for others they just aren’t a good idea.
A little background: A Roth IRA conversion is the process of moving money directly from a pretax account, such as a traditional IRA or 401(k), to a post-tax account (Roth IRA) and paying the tax bill in that year. This strategy has picked up momentum in the last few years, thanks to today’s historically low tax environment.
I go to the grocery store a few times a week and enjoy trying new things, but there are also the staples. One of those is coffee. If I walk into Whole Foods and the Peet’s bag I normally buy for $10 is on sale for $7, I will stock up. The yellow tag below the coffee will tell me how long the sale will last. I save 30% for every bag I buy. No-brainer, right?
Sign up for Kiplinger’s Free E-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.
The idea behind a Roth conversion is the same. You are stocking up, or pre-paying taxes today, to avoid paying them in the future. The only reason this would make sense is if you believe that your future tax rate will be higher than your current tax rate. Time horizon is not a factor, despite what you might read. It is simply a bet: current tax rate < future rate. The challenge is that there is no definitive yellow tag saying when and how much those tax rates will go up.
The case for Roth conversions: Two examples
1. You are in a tax valley.
We have a client, Jim, who has been retired for a few years. His wife, Susan, is retiring on December 31. They worked and had good incomes for full careers and are now in their mid-60s. Once Susan’s wages drop off of the 1040, their taxable income will be lower than it has been in decades. They will live off cash and taxable investments.
At age 70, they will both have turned on Social Security, and by 72, they will be taking required minimum distributions (RMDs) from their retirement accounts. All else being equal, their taxable income, and thus, their tax bracket, will pop back up. That window of opportunity is a “tax sale” from age 65-70/72, when they could pay at a lower tax rate when moving money from a traditional IRA to a Roth IRA.
2. You believe tax rates will go up.
Oh boy. People are passionate about this one! Whether it’s our ballooning debt, the upcoming election or the fact that our current tax code is set to expire on December 31, 2025, this may be a reason to pay now.
Even if nothing else changes in the next year, rates are set to go up with the expiration of the Tax Cuts and Jobs Act (TCJA). Like the previous example, this creates a sort of tax holiday for those who saw their tax bill drop thanks to the TCJA.
The case against Roth conversions: Two examples
1. You are in your peak earnings years.
Imagine the Peet’s Coffee example above. What if you walked into the store and instead of the bag costing $10, it’s $13? You would not buy that coffee until it dropped back down to a reasonable rate.
If you believe you are in your peak earnings years, on the verge of retirement, you should not convert. You will pay a premium on every dollar converted. Instead, you should be searching for deductions. You should defer your income until you can recognize it in a future, lower-tax year.
2. You are not liquid.
Let’s say you convert $100,000 from a traditional IRA to a Roth IRA and owe $25,000 in taxes for the conversion. While certain custodians will allow you to withhold those taxes and let the $75,000 grow tax-free, you typically want to have significant liquid funds to cover the tax bill from a separate pot.
The first reason for this is relatively straightforward: Tax-deferred accounts grow faster. So, if you have a choice of earning a 7% return in a taxable account or a 7% return on a Roth account, you would choose the Roth. Therefore, when figuring out which pot you want to turn over to Uncle Sam, pick the taxable.
If you’re under 59½ and use the IRA funds to pay the tax bill, you’ll also pay a 10% early withdrawal penalty on that distribution. At the end of the day, if there is not enough money on the sidelines to pay the tax bill, work on that before moving on to conversions.
Slow and steady wins the race
We save certain clients significant tax dollars by doing Roth conversions over a period of years. The caveat to all of this is that you must know what you are doing. I have seen entire IRAs converted in a single year, with almost half the value of the account going to taxes.
If you put yourself in the first category and think a Roth conversion makes sense for you, the tricky part is the calculation. You should seek the help of a CPA or CFP. Typically, we will do a tax projection for the year to estimate your taxable income. We will then figure out how much “headroom” we have, or how much income we can realize before we jump into the next income tax bracket. We will usually convert that amount over a period of several years. However, don’t forget the impact your income can have on capital gains and Medicare premiums!
Yes, Roth conversions are trendy in the small world of financial planning. And yes, for a small segment of the population, they can save big tax dollars. But ask yourself: Are you willing to write the check?
Related Content
- Are You a Baby Boomer With Too Much Cash? Three Scenarios for What to Do
- Asset Allocation for Retirees: Five Things to Consider
- Five Ways to Make Retirement a Little Less Scary
- Retired and 'Stuck' With a Mortgage Below 4%? You Have Options
- Six Essential Retirement Strategies for Baby Boomers
-
You Don't Have to Be Wealthy to Need a Wealth ManagerNavigating complex financial decisions is hard on your own, no matter how much money you have. A wealth manager can provide comprehensive financial planning, investment management, risk management and more.
-
Despite Tariffs, These Investment Experts Are Bullish on European EquitiesEuropean equities were one of the better-performing investments during the first half of 2025. They could be a good long-term prospect for U.S. investors needing to diversify, according to these investment managers.
-
How Do You Know You Are Ready for a Gray Divorce? 15 Yes-or-No QuestionsAs people 50 and older get more gray divorces, many splits are initiated by women who want a new path. Answer these 15 questions to see if you might need to think about how you should move forward.
-
'Buy Now, Pay Later' for Everyday Spending? This Financial Pro Thinks It's Risky'Buy Now, Pay Later' apps can get you out of a jam when you need money quickly. But using them regularly for small purchases could create problems.
-
Five Things to Consider Before Rolling Your 401(k) into a Roth IRAConverting at least some of an old 401(k) to a Roth IRA can offer long-term tax benefits and retirement flexibility, especially if you anticipate being in a higher tax bracket later or wish to leave a tax-free legacy.
-
From Dream Apartment to Nightmare: When Your Landlord Evicts You Through No Fault of Your OwnThis is what I suggested a tenant do to get out of her lease after her landlord's inexperience and lack of action made her rental situation unsafe. It's a legal situation called 'constructive eviction.'
-
Six Steps to Being Empowered and On Track: An Expert Financial Guide for WomenWhile most female investors feel on track with their financial goals and empowered by managing their investments, many regret not starting sooner. Here's how you can get started and take control of your financial future.
-
Selling Your Business? This Powerful Insurance Option Unlocks Multigenerational WealthPrivate placement life insurance (PPLI) offers almost unbelievable investment flexibility, estate planning and tax advantages. And it's completely legit.
