When Roth Conversions Don’t Make Sense: Understanding the Hidden Costs
Roth conversions are often promoted as one of the smartest tax strategies in retirement planning but they’re not a one-size-fits-all solution. While converting your traditional IRA or 401(k) to a Roth IRA can provide tax-free income in the future, there are situations where it could backfire, leading to higher taxes, reduced benefits, or unnecessary financial strain. Understanding when not to do a Roth conversion is just as important as knowing when it makes sense.
One major red flag is if you’re currently in a high tax bracket for example, 32% or 35% and expect to be in a lower bracket (such as 12% or 22%) during retirement. In that case, converting now would mean paying more tax than necessary. For modest income earners, the benefits can also be minimal. Many retirees benefit from the standard deduction, which increases after age 65, effectively reducing taxable income. In these cases, the tax advantage of converting to a Roth can disappear altogether.
Paying taxes with IRA funds instead of outside cash can also undermine the purpose of a conversion. Not only does it reduce the amount moved into the Roth, but if you’re under age 59½, it could trigger early withdrawal penalties. Similarly, if you plan to use the money soon, a Roth conversion may not be ideal due to the five-year rule, which requires each conversion to age for five years before earnings can be withdrawn tax-free.
Large conversions can have ripple effects beyond taxes. They can push you into a higher tax bracket, raise Medicare premiums, and reduce ACA healthcare subsidies. And if you have a shorter life expectancy due to health concerns, the long-term benefits of tax-free growth may never be realized. In some cases, leaving a traditional IRA to low-income heirs can be more beneficial they might pay less tax on withdrawals than you would on a conversion today.
Consider this real-world example. A couple, both 65 or older, earns $60,000 annually through Social Security and traditional 401(k) withdrawals. Their taxable income sits around $45,000, resulting in a federal tax bill of only $215. However, if they converted $40,000 from their IRA to a Roth, their taxable income would jump to $70,000, and their tax bill would skyrocket to $6,819. Even after factoring in the Over-65 Senior Deduction (OBB), their total taxes would still increase substantially. This simple example shows how even small conversions can have outsized tax effects.
Before making a conversion, it’s crucial to consider how you’ll pay the taxes, when you’ll need the money, and how long you expect to hold the account. Using outside funds to pay taxes maximizes the amount that grows tax-free, while timing conversions during lower-income years can minimize the tax hit. Be aware that large conversions can also affect Social Security taxation and Medicare IRMAA surcharges.
Of course, Roth conversions still have clear advantages. They reduce future Required Minimum Distributions (RMDs), allow heirs to inherit funds tax-free, and create tax diversification giving you more flexibility in managing retirement income. Paying taxes now can also offer peace of mind, especially if you believe tax rates will rise in the future.
In the end, Roth conversions make the most sense when you’re in a low tax bracket, have decades for tax-free growth, or hold large traditional IRA balances that could create future tax problems. But for retirees with modest income, short-term needs, or limited time horizons, conversions could do more harm than good. The bottom line? Always run the numbers, and if the math doesn’t add up, it’s okay to skip the conversion. A well-timed strategy is better than an automatic one.
All writings are for educational and entertainment purposes only and does not provide investment or financial advice of any kind.
