Many people see converting to a Roth account as a wise financial move. Advisors frequently recommend this approach, and online tools often present it as a way to save on taxes.
The concept is relatively straightforward: you pay taxes now and transfer funds from a pre-tax retirement account into a Roth account, where the money can grow tax-free and be accessed later without tax implications.
Yet, these calculators don’t capture the entire picture. Roth conversion isn’t solely about taxes; it’s also a gamble on how long you’ll live, how the market performs, and what future tax rates may look like. Basically, this strategy tends to work if you’re currently in a lower tax bracket but expect to be in a higher one during retirement, and importantly, if you live long enough to make back the taxes you’ve paid upfront.
For a lot of folks—especially those planning to retire with savings under $2 million—the chances of benefiting from this move are minimal. Let’s dig into some of the potential drawbacks associated with making the switch to a Roth.
If you’re converting assets from a 401(k) or traditional IRA to a Roth, you need your investments to grow sufficiently to counterbalance the taxes you’ll pay during conversion.
Take, for instance, a scenario where you convert $100,000 and owe $20,000 in taxes. It could take years for that remaining $80,000 to outpace your tax costs on the original amount.
Generally, the longer you wait to invest and the less you pay upfront in taxes, the better your returns can potentially be, as noted in some research by the Financial Planning Association.
Many financial advisors and online calculators assume a retirement period of around 30 years, giving ample time for any conversion strategies to yield results.
However, in reality, many people’s retirement spans are often shorter. If you retire at 62, your life expectancy may be around 19.6 years. For those who retire at 67, it could drop to just over 16 years, according to actuarial data from the Social Security Administration.
Given the taxes incurred during the conversion, there might not be sufficient time left to realize any significant advantage.
The core idea behind Roth conversion is to pay taxes now to prevent future taxes during retirement. Still, if you find yourself in a higher tax bracket today, that exchange may not hold up.
Consider a successful business owner with a 32% marginal tax rate applicable to Roth conversions. Yet, she anticipates that most of her retirement income will derive from capital gains, which may only be taxed between 15% and 18%. Paying 32% now to escape a future tax rate of up to 18% often doesn’t seem worth it. Very few retirees face the highest tax rate on every withdrawal, but high earners usually do in their working years.
Considering expectations about lifespan and the possibility of lower tax rates in retirement, Roth conversions might not be suitable for many current savers. However, individuals with significant pre-tax assets—perhaps $2 million or more—might gain more from this approach.
A Roth conversion can be appealing for those with larger pre-tax retirement accounts. Having a sizable nest egg could allow you to retire earlier, which gives you more time to take advantage of the benefits of your Roth conversion. Delaying Social Security benefits might also present an opportunity to switch while staying in a lower tax bracket.
A more considerable pre-tax account also raises the risk of required minimum distributions later, which can push you into a higher tax bracket, enhancing the attractiveness of conversion.
Ultimately, Roth conversions are not automatically “tax efficient.” The effectiveness of this strategy hinges on variables not entirely captured by online calculators. Keep these factors in mind as you map out your retirement strategy.
