Four Reasons To Avoid A Roth Conversion
For those unfamiliar with the term, a Roth conversion involves moving money from a tax-deferred traditional IRA (IRA) to a tax-free Roth IRA (Roth). You’ll pay taxes on the amount transferred but from that point on the amount will grow tax-free for the rest of your life (and even for ten years of a subsequent beneficiary’s life). The idea of tax-free income is so appealing that many investors can’t wait to convert all their IRA assets into Roth assets. However, there are times when a Roth conversion is not a good strategy.
Your current tax bracket is too high. This is probably the most common Roth conversion mistake people make. If you do the math you’ll discover that if your income tax rate were to remain constant over your lifetime, you’d end up with the same amount in an IRA (after taxes) as compared to a Roth. The only true reason to do a Roth conversion would be if you expected your tax rate in retirement to be higher than it is now, either due to higher future income, future government-initiated tax rate increases, or both. If you are currently employed and in your prime earning years it’s unlikely that your income will be higher after you retire, suggesting this would be a poor time to do a conversion. On the other hand, if you’re retired but younger than age 73 – the current starting age for required minimum distributions (RMD) from an IRA that will increase your taxable income at that time – a Roth conversion now might be appropriate. Also keep in mind that the income tax reductions in the Tax Cuts and Jobs Act (TCJA) passed in 2018 are slated to expire (i.e. increase) in 2026. But what the government does with tax rates beyond that year is a complete unknown.
You are charitably inclined. Did you know that once you turn age 70 ½ you can withdraw up to $100,000 each year from your IRA for charitable contributions and avoid paying income tax on the withdrawals? Such qualified charitable distributions (QCDs) are more tax-efficient than donating low-basis stock or cash because you don’t need to itemize deductions to claim them. In this case it would be better to leave the money in the IRA rather than moving it to a Roth and paying taxes on it. You can even use QCDs to eliminate the taxes incurred by RMDs.
You own your own business. Whether you are an independent contractor, a partnership, or an S corporation, you are entitled to a 20% pass-through deduction on your net income, again thanks to the TCJA legislation. This so-called qualified business deduction (QBI) has income limitations depending on the type of business you operate. In 2023 the limit is $364,200 for married couples and $182,100 for single tax filers. The additional taxable income generated by a Roth conversion could put you over the limit and prevent you from getting the QBI deduction.
You are on Medicare. Medicare premiums are based on your income. If your income exceeds certain thresholds an additional income-related monthly adjusted amount (IRMAA – don’t you love government acronyms?) will be added to your monthly Medicare payments. As with QBI limits, a Roth conversion could increase the amount you have to pay for Medicare coverage. And the IRMAA calculation is based on your tax filing from two years earlier. So making a Roth conversion in 2021 could negatively impact your Medicare premiums in 2023.
These are not the only times when a Roth conversion may not make sense. Although a conversion can be an effective way of increasing your after-tax wealth, you need to be aware of the broader tax-planning implications before deciding to do one.
Seems to me this can be generalized as: When in retirement you have more control over your taxable income, such as by optional (non-need) distributions or conversions, or earning more income, seek to remain in, but fill, the same tax bracket (real or effective, including marginal issues like IRMAA) for the rest of your life, avoiding tax-inefficient income spikes or RMDs later forcing you into a higher bracket.