Last year, I published an episode titled, 5 Reasons Not to Do a Roth Conversion.
In short, the 5 reasons were:
- Shadow taxes
- No undo button
- Lack of cash flow to pay the tax bill
- You simply don’t want to
- Future charitable giving
Today I’m sharing three (more) reasons why Roth conversions might not make sense and why it may be ok to leave money in your pre-tax IRA.
In fact, one of the reasons includes a creative way to pay for long-term care expenses in retirement. 😳
If you’re ready to continue learning about this popular tax strategy and better understand when it doesn’t make sense to pursue it, today’s episode is for you.
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3 (More) Reasons NOT to Do Roth Conversions
Taylor Schulte: Last year, I published an episode titled, 5 reasons not to do a roth conversion.
In short, the 5 reasons shared were:
Shadow taxes (i.e., IRMAA surcharges and The Premium Tax Credit)
No undo button (unlike contributions, you can’t undo a conversion)
Lack of cash flow to pay the tax bill
You don’t want to
Future charitable giving goals
Roth conversions are all the rage with retirees. Just about every retirement podcast, newsletter, blog, YouTube channel, has content dedicated to this “magical” tax planning strategy, including this one.
And, look, I love roth conversions. I think they can be wildly beneficial for the right person. But they are often talked about like they’re a no-brainer and anyone with pre-tax assets should be converting them to roth and those don’t are making a big mistake.
Baron’s recently wrote an article titled, “Roth IRA Conversions: The Best Tax Move You Can Make Right Now.”
Nerd Wallet wrote one titled, “Roth Conversion Ladders Can Combat Inflation.”
And then CNBC chimed in with one that said “Now is the Perfect Time for Young Investors to do a Roth IRA Conversion.”
While roth conversions can be great tax moves and could be fitting for some young investors, the decision to convert isn’t nearly as simple as these headlines suggest. This strategy isn’t a magic bullet or a no-brainer for everyone. There are a lot of things to take into consideration, a lot of moving parts, and a lot of nuances.
Skipping roth conversions altogether likely won’t break your financial plan. On the other hand, incorrectly pursuing them could create a massive tax drag on your retirement portfolio, reducing the long-term success of your plan.
Welcome to the stay wealthy podcast, I’m your host Taylor Schulte, and to build on last year’s episode, today I’m sharing three more reasons why you shouldn’t do roth conversions and/or why it’s ok to leave money in a pre-tax IRA.
To grab today’s show notes – which will include links to last year’s episode as well as the two-part roth conversion series I published on the podcast as well – just head over to youstaywealthy.com/190.
Roth IRA conversions are different than Roth IRA contributions. Let’s get that out of the way first, because it always causes some initial confusion.
Roth IRA contributions are when you earn an income from working, pay taxes on that income, and then contribute a portion of your after-tax dollars to a Roth IRA. There are limitations on how much you can contribute and also limits on who can contribute.
For example, if you are a single filer, you begin to get phased out of making roth contributions if your Modified Adjusted Gross Income is above $138,000 here in 2023. If you make $153,000 or more, you are completely phased out and cannot contribute a single dollar to a Roth IRA this year.
So, roth IRA contributions have limitations.
Roth IRA conversions, on the other other hand, don’t. A Roth conversion is the process of transferring money from a pre-tax retirement account into an after-tax Roth IRA.
Examples of pre-tax retirement accounts include Traditional IRAs, Traditional 401ks, SEP IRA’s, and Simple IRAs. While inherited IRAs are TECHNICALLY pre-tax retirement accounts, they CANNOT be converted into Roth IRA’s.
As noted, there are no limitations with roth conversions. If you have $1 million in a Pre-Tax Traditional IRA, you can technically convert all $1 million of it tomorrow into a Roth IRA if you wanted.
There is no age requirement or limit to the amount. If you want to convert every single dollar tomorrow you can. The converted dollars will grow tax-free forever in your roth IRA, you won't have to worry about RMDs at age 73 or 75, and if applicable, your heirs will inherit this nice pot of tax-free money.
The kicker here, as most know, is that taxes are owed on the amount of the conversion the year in which it was processed. So if you convert all $1 million to a Roth IRA tomorrow, you will pay ordinary income taxes on that $1 million just as if you earned that money working. This $1 million addition to your taxable income would, naturally, drive you into a higher tax bracket and cause other assets and income to become more taxable as well. It would also likely result in you paying more taxes to the IRS over your lifetime.
Since there aren’t any limitations to the timing or amount of roth conversions, it’s entirely up to retirement savers (and the professionals they work with, if applicable) to determine when and if roth conversions make sense.
I published a two-part deep-dive series walking through how to evaluate roth conversions last year. So if you missed it, or want to revisit it and brush up on all the nerdy details of this tax strategy, I’ll link to in today’s show notes.
But in today’s episode I’m sharing three reasons why someone may not pursue roth conversions. Or, in some of the cases, why it’s ok if you skipped roth conversions or weren’t able to convert everything before your opportunity runway ended.
It could certainly make sense to convert SOME money to a Roth IRA and SOME point in time, but I often hear retirement savers kicking themselves because they aren’t able to convert everything in time and wishing they started conversions earlier.
Roth conversions can be a great tax move, but as I’m sharing today, and as I shared in last year’s episode, there are plenty of reasons not to do them and plenty of reasons why you may not want to convert every last dollar.
So, reason #1 why you may not do a roth conversion or why you might be ok leaving some money in a pre-tax IRA is that you can use your pre-tax IRA money as a creative way to tax-efficiently pay for Long Term Care expenses later on in retirement.
This strategy essentially takes advantage of the often overlooked Medical Expense Deduction, or IRS Publication 502. In short, medical expenses, including LTC costs, can be deducted on Schedule A of your tax return. The full-length publication even has a clear definition of “Long Term Care” services, inclusive of a section dedicated to nursing homes.
Specifically, it states,
“You can include the cost of medical care in a nursing home, home for the aged, or similar institution, for yourself, your spouse, or your dependents. This includes the cost of meals and lodging in the home if the principal reason for being there is to get medical care.”
It continues by saying that you can also include,
“the cost of lodging not provided in a hospital or similar institution”
if it meets certain criteria. Simple things like the lodging has to be primarily for medical care, there is a licensed doctor there, lodging isn’t extravagant, etc.
More often than not, when we do a long-term care analysis for a client, the conclusion is that we should skip buying long-term care insurance and instead plan on self-funding. I.e., if a long-term care event occurs, the costs will be paid out of pocket by the client instead of tapping into an insurance policy. If you want to learn more about analyzing the need for long-term care insurance vs self-funding, I’ll link to the series I did on this topic in today’s show notes which can again be found by going to youstaywealthy.com/190.
So, when it comes to self funding for long-term care, a helpful way to implement this into a financial plan is to carve out a certain dollar amount from retirement savings and put it in its own individual investment account, earmarked specifically for a future potential long-term care event. This allows the client to keep the money invested, perhaps invest it a little differently given that it has a different goal than their other retirement savings, and compartmentalize exactly what those dollars are for.
In some cases, a client's nest egg may be mostly made up of pre-tax IRA dollars or they need the after-tax money they do have to fund other near-term expenses. In these cases, we’ll simply open up another pre-tax IRA for the client and transfer the amount we’ve decided to earmark for long-term care from their primary IRA to this newly opened IRA. It’s a lateral transfer from one pre-tax IRA to another, so there’s no tax consequences.
We’re just creating a bucket (if you will) that is specifically setting aside and earmarking dollars for a potential long-term care event in the future. By keeping these funds in their own account, we prevent everything from getting comingled and we can sleep at night knowing that there is a plan for a potential long-term care event in the future.
We’re not just saying that “we will self fund” and hoping nothing happens – we’re taking action and earmarking dollars for that potential event; planning for the worst and hoping for the best.
So, if money earmarked for long-term care expenses is in a Traditional IRA, and a long-term care event occurs in retirement, the client can take money out of that pre-tax account to pay for the medical expenses. Taking money out of the IRA is a taxable event, however, the client can immediately turn around and deduct the qualified medical expenses on Schedule A of their Form 1040.
One important thing to take note of here is that the IRS only allows you to deduct the amount of your total medical expenses that exceed 7.5% of your adjusted gross income (or AGI). So, if your AGI is $100,000, you can only deduct expenses above $7,500. If your AGI is near $0 because you don’t have any taxable income sources, keep in mind that the IRA withdrawal in this example will cause your AGI to spike.
For example, let’s say you have $100,000 of long-term care expenses in one year. All you have is pre-tax IRA dollars to pay these expenses, so you withdraw $100,000 from your IRA. That $100,000 will now be added to your gross income and you’ll only be eligible to deduct expenses above $7,500 (or 7.5% of your AGI).
While you weren’t able to deduce the full $100,000, you were still able to get funds out of your pre-tax IRA at a very favorable rate, perhaps a rate lower than if you had converted every last dollar to a roth earlier on.
As always, there are a number of nuances to take into consideration here. And it likely isn’t wise to intentionally skip roth conversions just so you can POTENTIALLY use pre-tax IRA dollars in the future to tax efficiently pay for a long-term care event. A long-term care event may never occur – or may not be a significant cost.
So, this is not exactly something you can plan for. But if you have pre-tax dollars left over when your roth conversion opportunity window ends, just know that those dollars could be earmarked for a future medical event.
Also, as discussed in the episode we did last year on this topic, any excess dollars left in a pre-tax IRA that aren’t needed to fund retirement or a long-term care event can also be used to give to charity, either at end of life or through annual Qualified Charitable Contributions (or QCDs). In other words, not converting every last dollar allows you to maintain some tax diversity through retirement and potentially meet other future goals tax-efficiently.
Lastly, you might have caught me saying earlier that the IRS also allows you to deduct medical expenses, including eligible long-term care expenses, for dependents, which presents another interesting use case here. You may not have a long-term care event, but it’s possible that you end up caring for an aging parent who has one, or needs nursing care.
If they meet the criteria to be claimed as a dependent and you determine that claiming them as a dependent is best for the situation, you can deduct those eligible medical expenses that are incurred on your tax return and apply the same concepts I’ve discussed here today.
Ok, the second reason not to do a roth conversion is your state of residence in retirement. There are 13 states (previously 12, but Iowa was added to the list this year) that either don’t have income tax at all and/or don’t tax retirement income distributions from pre-tax accounts like 401ks and IRAs.
So, if you currently live in a high tax state or a state that taxes retirement account withdrawals, but you plan to relocate to one of these 13 states in retirement, you may not benefit from doing roth conversions. It may be wiser to skip roth conversions and withdraw money in retirement as needed once your settled in your new, retirement and income-tax friendly state.
There are still some unique situations that would justify roth conversions before relocating such as prolonged unemployment and a significant difference in current Federal tax rates versus future, but more often than not, paying state income taxes on roth conversions when you plan to relocate to a more tax-friendly state when retirement distributions kick in likely doesn’t make sense.
By the way, I did an entire episode on state income taxes and shared several myths around high-tax states like California. So, be careful not to accept the headlines you’ve seen about state taxes at face value and dig into the details to see exactly how different states impact your tax rates. You might be surprised to learn that some states that have earned a bad reputation aren’t actually all that bad for your personal situation. I’ll link to that episode in the show notes if you’re interested in listening which can again be found by going to youstaywealthy.com/190.
Ok, so the second reason why you might not rush to do roth conversions is your state of residence in retirement.
The third and final reason not to do a roth conversion is if you plan to leave money to your heirs and you anticipate that they will be in a lower tax bracket than you. Perhaps they reside in a more tax-friendly state or simply maintain a lower taxable income for any number of reasons.
If your pre-tax IRA dollars – or a good chunk of those dollars – are destined for your heirs who will likely be in a lower marginal tax bracket, then it likely doesn’t make sense to intentionally hand over more money to the IRS while you’re alive. If your goal is to maximize wealth for future generations and you don’t want to overpay the IRS, it would make sense to let those with the lowest tax rates pay the tax bill.
Keep in mind, if IRA dollars are left to someone other than an “eligible beneficiary” who is exempt from the new 10-year rule, they will be forced to withdraw the entire IRA balance and pay all of the associated taxes within a 10-year time period. They could withdraw everything in year one, everything in year 10, or take a little out each year as they see fit.
But everything has to be exhausted within 10 years. Given that, it would be important to factor in this 10-year time period your heirs have to spread out the tax consequence to determine if they will truly be able to get money out a lower tax rate than you.
It’s also worth noting here that maybe you plan to leave a healthy % of your retirement savings to your kids or grandkids but you aren’t really concerned with what their tax rate might be at the time of inheritance and if it will be lower than yours. Heck, they might not care either.
As my friend Matt often says when someone complains about a tax bill,
“give me your income – or in this case – give me your IRA and I’ll pay the taxes.”
It may not be important to you to do roth conversions just so your heirs aren’t burdened with a tax bill on their inheritance. And it may not be important to you to go through the hassle of determining who will be in a lower tax bracket and how much, if any, pre-tax IRA dollars should you try to convert while you’re alive.
But if maximizing generational wealth is important and you want to ensure that you’re family – as a single unit – is paying the least amount of taxes possible, it would be wise to determine if it makes more sense to leave money in the pre-tax IRA and let your heirs in more tax-friendly situations pay the taxes when the funds are inherited.
Ok, to recap, the three reasons why you may skip roth conversions or simply be ok with leaving a balance in your pre-tax retirement accounts are:
To tax-efficiently pay for Long Term Care expenses later on in retirement
You’ll be in a more tax-friendly state when retirement withdrawals begin
You plan to leave money to your heirs and anticipate they will be in a lower tax bracket than you
As with most things, the decision to convert or not depends on dozens of different factors. Age, life expectancy, current and future income, geographical location, charitable giving goals, medicare premiums, changes in tax laws, the list goes on.
The goal of considering roth conversions year over year is to ensure that we don’t overpay the IRS. We want to pay our fair share in taxes, of course, but I think it’s safe to say that most of us don’t want to pay more than we have to. We don’t want to leave the IRS a tip just because we were lazy with our tax planning and weren’t proactive.
And that’s exactly what we’re doing when we are evaluating roth conversions (and other tax planning strategies)...we are being proactive. We’re looking at our current situation, projecting where we will likely be in the future, and then making an educated decision to determine if taking action makes sense.
What we want to avoid is retiring from decades of work, celebrating our ultra low tax bracket during our gap years when income shuts off, and then waking up at age 73 or 75 when RMDs kick in only to find ourselves in a similar or even higher tax bracket than when we were working.
Not only can this surprise cause cash flow issues and potentially cause someone to overpay the IRS over their lifetime, but it can also cause Medicare premiums to increase as a result of IRMAA surcharges and cause Social Security income to become more taxable.
So, while roth conversions aren’t for everyone – and there are plenty of reasons to skip this popular strategy – being proactive with our tax planning to evaluate all opportunities is a no-brainer for every retirement saver.
Once again, to grab the links and resources for today’s episode, just head over to youstaywealthy.com/190.
Thank you, as always, for listening and I will see you back here next week.
Episode Disclaimer: This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.