Don’t Overdo Roth Conversions

By Justin Pritchard, CFP®

Roth conversions can be a powerful strategy for maximizing your after-tax income in retirement. But some people can get carried away. The technique can be so alluring that people convert more than is necessary—and they might not need to convert at all. Ultimately, it comes down to your situation and preferences, but Roth conversions can sound like such a clever idea that they become irresistible.

Because of that, it may be helpful to explore when not to convert to Roth.

At the same time, let’s acknowledge that Roth conversions can have substantial benefits. When done correctly, they can help you maximize your retirement resources. But just like with rich chocolate cake, it’s possible to have too much of a good thing.

On this page:

  • Basics of conversions
  • Yes, there are advantages
  • Potential drawbacks
  • Why it might make sense to keep some pre-tax money
  • No, converting isn’t “bad”

Continue reading below, or watch this video with similar information:

Basics of Conversions

Just to make sure we’re on the same page, let’s review how Roth conversions work at a high level.

Roth conversions allow you to shift money from pre-tax retirement savings into after-tax Roth savings. Yes, you can also convert after-tax dollars in a backdoor Roth strategy, but we’re primarily talking about pre-tax balances that you’ve accumulated over many years. With this approach, you might convert a portion of your savings over a series of years (also known as partial Roth conversions), choosing the exact amount to take as income for each year.

When you convert, the amount you convert is treated as income. As a result, you’ll often owe income tax, although it’s possible to avoid additional taxation if your deductions completely offset the amount you convert. Or, if your income is low enough, your deductions could offset the income from conversions—but that’s not the reality for many people.

To fund the extra taxes due from a conversion, it typically makes sense to fund the payment from assets outside of your retirement accounts. In other words, having assets in bank accounts or taxable brokerage accounts is ideal for paying the tax.

Eventually, you may be able to withdraw the money you converted without paying income tax on your distributions. That assumes that you follow all IRS rules related to conversions, including reaching age 59 ½ and satisfying five-year waiting periods.

That tax-free treatment can be beneficial, and Roth conversions are often a good idea in certain situations:

  • Tax diversification: Choose where to draw funds from and how much taxable income to recognize when you need money.
  • Smooth out taxable income: By taking income early, you can potentially avoid income spikes later in life. That might help with the following items.
  • Manage RMDs: Get money out of pre-tax accounts early so that you can take smaller required minimum distributions (RMDs) after age 72. As a result, you may avoid getting bumped into high tax brackets
  • Reduce Social Security taxation: With a lower income, you could minimize the amount of Social Security income that you pay taxes on
  • Manage health care costs: Your income can affect how much you pay for Medicare or private insurance coverage. However, things can get complicated when you have conflicting goals (taking income today versus keeping income low to qualify for the lowest costs)
  • Plan for a spouse’s death: When one partner in a married couple dies, the surviving spouse often faces higher taxes after becoming a single filer. This is also known as the widow’s penalty.
  • Dodge tax increases: If you think that tax rates will rise in the future, this strategy allows you to pay at today’s rates.

Why Not Convert to Roth

While conversions may make sense in some situations, they’re not always the right move. The primary drawback of converting to Roth is that you get a higher income in the year you convert, and you must pay income taxes on the higher income. Doing so uses up money that you might put toward other uses.

Current vs. Future Income Tax Brackets

Converting to Roth makes the most sense when you’re in a relatively low tax bracket today and you’ll be in a higher bracket later in life. When that’s the case, it may make sense to pay taxes now, getting them out of the way. When you take distributions later in life—presumably in a higher-tax-bracket world—the money can come out of a Roth account tax-free (if you follow all IRS rules).

But you might not face higher tax rates later. Retirees tend to pay taxes at relatively low rates, and those over age 65 might get additional state tax benefits.

Overall, retirees pay roughly 6% tax on their income, according to a study from Boston College’s Center for Retirement Research. Of course, wealthier households could pay more, but you might pay less than you think.

When I review tax returns for clients, I often see them paying taxes at a somewhat low effective rate, which is usually lower than expected. Some clients even avoid paying tax on their Social Security benefits, even with modest assets in pre-tax savings.

Current and future tax rates aren’t the only thing to consider, but they are important.

The Cost of Extra Tax Payments

When you pay taxes to convert, you use valuable resources that could go toward other things. Converting less (or nothing at all) could leave you with more money to work with.

Your goals might be financial or non-financial. For instance, you might want to spend more on meaningful life experiences. If you’re converting to Roth at the expense of taking vacations with loved ones, is that the best use of your money? Maybe, and maybe not.

Likewise, conversions could strain your budget and prevent you from working toward other financial goals. If you’re not paying down debts, you might not come out ahead as much as you think, and it could make sense to skip Roth conversions for a while. Again, it just depends on the details, and you need to weigh the pros and cons of converting vs. paying down debts.

Remember that there is no “tax scoreboard,” and even if there was, the goal in life isn’t to see the lowest number possible there. The goal is ultimately to enjoy your time on this earth and do the best you can while you’re here.

Also, if you’re concerned about paying for medical care later in life, remember that extremely high medical costs could provide substantial deductions. In those cases, you can potentially fund your care from pre-tax retirement accounts with a relatively small impact.

Higher Income From Conversions

When you make conversions, any additional taxable income you receive could be problematic.

For example, it’s common to do annual conversions in the years between when you retire and when you begin taking Social Security benefits. However, you may have conflicting goals—there might be good reasons for keeping your income low during those years.

Your health insurance costs might depend on your income, and Roth conversions generally increase your income. As a result, you might pay higher premiums for private coverage or get smaller tax credits (ACA subsidies). When you’re 63 or older, it’s also important to watch for Medicare surcharge levels (IRMAA).

A higher income might cause other complications. Whenever there are income limits for deductions or credits, you need to be mindful of how much income you take. “Means testing” of any kind could disqualify you from certain benefits, so there may be advantages and disadvantages of converting to Roth.

Giving to Charity?

If you give money to charity, it could make sense to leave enough money in your pre-tax accounts to fund some giving.

This is even more critical if you plan to leave a pre-tax IRA to tax-exempt charitable organizations. Those organizations would not pay income taxes on the money, so you have no reason to spend your money on Roth conversions. In fact, doing so leaves less money for the charity—you’ll make a bigger impact if you don’t convert.

You can also give money to charity while you’re living. In particular, once you reach age 70 ½, you may be able to make qualified charitable distributions (QCDs). With that approach, you send money directly from a pre-tax IRA to a qualifying charity. When done properly, the funds are never reported as income, which can help to avoid complications on your tax return (and you don’t need to take a deduction). You give away pre-tax money—again, maximizing the impact you make for your favorite causes—and keep recordkeeping easy.

If you’re over age 70 ½ and you give money to qualifying charities, the best way to do so might be from your pre-tax IRA. Just make sure that you report any QCDs correctly on your tax return, as it can be easy to include the income accidentally.

Should You Avoid Roth Conversions?

None of this is meant to suggest that you shouldn’t convert to Roth. It can be done intelligently and provide valuable benefits. After running the numbers, you might decide to do a reasonable amount of conversions before age 72 while being mindful of health coverage costs. That’s great.

Plus, if you have more money than you know what to do with, it could be perfectly fine to convert more than you need to and pass Roth-type assets to the next generation. That way, your heirs don’t have to worry about paying income tax, and paying taxes from taxable accounts might be beneficial in reducing the size of your estate.

That said, you’ll want to have a well-defined strategy and rationale for any conversions. While you can’t predict the future, you can make reasonable estimates and informed decisions based on your projections. That’s probably the ideal approach to conversions. But converting with a vague goal of eliminating pre-tax balances is probably not your best bet.