Roth conversions are trendy. So much so, that I know if I write on the topic, you’ll click. Welcome! There is a strong case for this powerful strategy, just as there is for Ozempic. But like Ozempic, Roth conversions aren’t for everyone. Here are situations where I would urge you to punt or at least get a professional opinion.
- Peak earnings years
You’re five years from retirement, the light bulb has gone off, and you’re starting to devour retirement planning content. With that, a heavy helping of Roth conversions is now on your plate. Not so fast. At its core, a Roth conversion is a bet that your current tax rate will be lower than your future tax rate. If you walked into a grocery store and instead of a yellow sale tag, you saw a red tag that said everything is 20% more, you would skip the Cheerios and hope they come back to their normal price next week. You should do the same for the conversion.
While high wages were the primary example, the same logic applies to any income source that causes your taxable income to temporarily spike. Sold a stock with a huge gain? Punt. Sell the home you’ve owned for forty years? Punt. You get it.
- Under 59½ and illiquid
When we are doing conversions for our clients, we typically have a choice in how we pay the tax bill. You can pay from a liquid source like a bank account or brokerage account. This is often the most tax-efficient because it maximizes the amount actually making it into the Roth bucket. Alternatively, you can withhold taxes from the conversion just as you do when you take an IRA distribution. While this is not as tax-efficient, it is easier, and it makes the Roth conversion basically a cashless transaction.
Here’s where it can backfire: If you are under 59½, that withholding is generally treated as an early distribution and may be subject to the 10% early withdrawal penalty unless an exception applies. So, if you’re under 59½ and you don’t have cash or liquid investments you can use to foot the tax bill, you might want to, you guessed it, punt.
- Highly charitably inclined
I have had clients whose tax rates did not adjust upwards at required minimum distribution age (RMD) because they basically gave their entire RMD to charity via qualified charitable distributions (QCDs) and lived off of their other investments and income streams. The income spike that is caused by RMDs and Social Security in retirement is a large part of the reason why Roth conversions make sense. If your tax rate today is lower than it will be tomorrow, you want to stock up. Same idea as the Cheerios, but with a yellow tag. It’s a tax sale. Without the future spike, you don’t need to stock up.
- Bumping up against punitive thresholds
I have written more detailed columns on Roth conversions (for the clicks) where I talk about the need to evaluate not only income tax brackets but also capital gains brackets, Medicare thresholds, and now OBBBA-related phaseouts, when doing a Roth conversion. Sorry for the Latin! Simply put, you cannot or should not say: I have $100,000 left in the 24% tax bracket, so that’s how much I’ll convert. Doing that may trigger a different, unexpected tax.
We have retired CPAs as clients who will do anything in the world to avoid the Medicare (IRMAA) thresholds. I get it; no one wants to pay more for the same thing. Yet sometimes crossing those thresholds makes sense for future savings. It all depends on how much your taxes will rise in the future.
Let’s not forget that Roth conversions are trendy for a reason. Depending on an investor’s circumstances, lifetime tax savings can be substantial and may reach six or even seven figures. We do them for many clients. But just as a doctor has to write you a script for Ozempic saying it makes sense for you (I think), I’d recommend having a financial planner or tax advisor write a script for the Roth conversion.
This article is provided for informational and educational purposes only and should not be construed as investment, tax, or legal advice, or as a recommendation regarding any particular strategy. Whether a Roth conversion is appropriate depends on an individual’s financial circumstances, tax situation, investment objectives, and applicable law. Tax laws are subject to change and their application may vary. Examples discussed are hypothetical and are intended solely to illustrate general planning concepts. They do not reflect the experience of any specific client or guarantee future results. Consult your financial, tax, and legal advisors before implementing any strategy.