Roth conversions: When do they not make sense?

A Roth conversion may seem like a magic trick to boost your retirement savings, but it can be more tricky than magical.

Roth accounts are popular because the distributions from the accounts can be withdrawn tax-free. How do they swing that? You pay taxes upfront on the contributions. But here’s the trick: You can convert funds from a pretax account like a 401(k), 403(b) or governmental 457(b) plan into a Roth account by paying taxes on the funds when they’re transferred.

The key phrase here is “depending on your situation.”

There’s no one answer

While this article is about the challenges that can emerge with Roth conversions, we also believe there are several advantages that Roth conversions can offer even beyond tax-free distributions. For example, as of 2024, Roth-designated 401(k) and 403(b) accounts are no longer subject to Required Minimum Distributions and that could eventually have positive knock-on effects, like lowering Medicare premiums and taxes on your Social Security income. 

But, as Ernst says, there are no free lunches. When you’re near or in retirement, obstacles that a Roth conversion may present can be particularly relevant.

1

Your taxes can increase

• If you’re nearing retirement, there is a greater probability of your having the highest seniority you’ve ever had in your career, so your salary may be near or at its highest. That means your tax bracket is too. Funds that are transferred from a pretax account to a Roth are subject to income taxes. You could be converting at a time when you would be paying the most taxes on the conversion. 
• Converting increases your income in the year you convert, so depending on how much you convert, a conversion itself could bump you into a higher tax bracket.
• While a conversion could eventually lower Social Security taxes and Medicare premiums, a conversion could initially result in some (or more) of your Social Security benefits becoming taxable because of the increase in income that year. Also, if you’re covered, your Part B premium is based on your income, so a conversion could increase your monthly Medicare costs for a year or more (if you convert over a period of years). 
• Are you considering a Roth conversion in retirement because you fear the government will be raising taxes? Then also consider this: You won’t be earning a full-time salary during retirement, so that decreases the chances of your income taxes being higher. Also, over the long term, income taxes have been trending lower, not higher. The new administration has proposed making the current tax law permanent, which could decrease the chances of taxes rising for many of us.

2

It may take a long time to recover the cost of conversion

• After you convert, your overall wealth may be lower due to the taxes you paid on the conversion. You will want the Roth account to not only gain enough to make up for this loss but to exceed it to help make the conversion worth it.
• Depending on the amount of taxes paid, that could take years. If you’re near or in retirement, are you comfortable with that?

3

It costs money – sometimes a lot

• There are several ways to help pay for the taxes you’ll owe from a Roth conversion, and each can have downsides.
• One way is to use your cash reserves. As a general rule, we recommend that your cash reserves equate to six to 12 months of living expenses when working and 12 to 24 months when you’re in retirement. A conversion can be a big drain on your cash. For example, if you were to convert $100,000 and used $24,000 from your cash reserves to pay taxes on that distribution, how much cash will you have left?
• You can also have taxes withheld from the amount you convert from the pretax account into the Roth account. This lowers the amount of funds that make it into your new Roth account, however.
• The other option is to settle up at tax time if you’re expecting your overall tax situation to create offsets to the conversion’s taxes. For example, maybe you expect to have more deductions or credits than usual. However, you run the risk of miscalculating these tax offsets and owing more than you thought, especially if you don’t work with a tax professional who can help you with these calculations.

4

Converted funds can be ‘LOCKED UP’ for years

• Taking distributions from converted Roth accounts without penalties and taxes can be a headache that delays access to the funds. As you consider retirement, how comfortable are you with waiting to access these funds?

Two five-year rules for Roth conversions

• The first requires that you have the account open at least five years and be at least age 59½ to make a qualified distribution (i.e., no taxes or penalties).
  There is a potential workaround if your 59½ or older: You have only one five-year holding period required for all of your Roth accounts. So, if you had funded a separate Roth account 10 years previous to the conversion, you’ve met the five-year holding period.
  
  Retirees take note: Even after you’re 59½, you need to wait until the converted account is five years old to withdraw the account’s earnings tax-free, provided you never had a Roth account before.
  
  If you meet the requirements for a qualified distribution under the first rule, then you don’t have to worry about the second rule.
  
  
• The second five-year rule dictates that if you’re under the age of 59½, you can’t withdraw any of those funds without a 10% penalty. This second rule will apply to each converted account separately.
• The five-year holding period starts on the first day of the calendar year in which the Roth account received the converted funds. 

5

Can you predict the future?

• A major reason to do a Roth conversion is that you believe your taxes will be higher in retirement, so you want to lower your tax liability in the future. However, none of us have a crystal ball. Your tax liability could end up being much lower than you thought in retirement, even without the conversion. 
• You also don’t know with certainty the most opportune time to do a conversion. For example, let’s say you convert funds in a down market at the start of the year because it lowers the value of the funds and the taxes you would pay on them. However, it turns out, given your seniority at work, you get a big bonus at the end of the year, which puts you in a higher tax bracket. So perhaps that wasn’t the best year to do the conversion.

As you can see, Roth conversions, like many financial planning decisions, have their complexities. Ultimately, a Roth conversion could end up being right for you, even if you’re in or near retirement, so work with your planner and tax professional to help you weigh the pros and the cons if you’re considering one.