Is a Roth Conversion Right For You?

Have you ever wondered if a Roth conversion was right for your specific situation or financial plan? We’re going to take a deep dive into how we utilize Roth conversions into clients planning and when it may or may not make sense, depending on your circumstance. So a lot of information you’ll read on pros and cons of Roth conversion online, but we’re going to simply go through what this means and go through all details. So what a Roth conversion is taking pretax money that’s in an IRA. So this has not been taxed yet. So if you have put in, we’ll use any pretax IRA, 401k, any contribution that you make. You’re either, if you’re under a certain income threshold, you’re able to take a tax deduction. If you’re not, it could be after tax.

We’re going to go ahead and assume that one way or the other, the money is, there’s been a deduction taken, whether it’s through an IRA or 401k. For the sake of this video, it doesn’t really matter. But let’s just say you’ve put in round numbers $100,000 and that 100,000, when you’ve put it into the IRA, you’ve taken a tax deduction on that. So if you’re maxing out a 401k, for example, and you’re putting in 2024 limit is $23,000. If you’re under the age of 50, that qualifies for a full tax deduction. If you’re doing pretax contributions, let’s assume you’ve done that over the course of a few years, and you’ve since rolled that to an IRA. You have $100,000 in a pretax IRA, and when that money comes out, it gets taxed at ordinary income rates.

And so that rate now goes between ten and 37%, depending on your income and your tax filing status, your tax bracket, et cetera. What a Roth conversion is we can take money that’s in this pretax IRA, this 100,000 that at some point you have to pay taxes on it. So as this account begins to grow and accumulate, you’re just increasing your tax bill down the road. We can volunteer to take money from the IRA, pay taxes now, send a check to the IRS. The year you do that, you realize this is income, but then what? The money is in a Roth IRA or 401K. But we’ll say IRA for the sake of this example. Now we have 100,000 in the Roth IRA, and all of the accumulation you don’t pay any taxes.

All the distribution comes out tax free and passes to beneficiaries tax free. So we’re going to go through pros and cons of a Roth conversion. Why? This may make sense, but from a just technical, logistical standpoint, that is the concept. In this example, we’re going to assume 37% tax bracket when they do this. So to do the $100,000 Roth conversion federal taxes, we pay 37,000 to get the money into the Roth. But obviously, the longer this accumulates, all of the growth is tax free forever. We’re going to go through why this may make sense. So in 2018, there was a pretty significant tax overhaul put in place, and this is going to be in place until 2026, and then it’s going to revert back to the 2017 tax code. So again, right now, marginal tax rates go from zero to 37%.

Right now, if you’re married filing joint, the 37% tax bracket kicks in at about $693,000. And so why this is important. If were to look back at historic marginal tax rates, which is what this chart shows, one thing that’s remained pretty constant is this blue line, and that’s what low income earners will pay has been between zero and 20%. One thing that no matter who’s in Congress, the White House, et cetera, lawmakers, they’ve always agreed low income earners should pay less in taxes. What’s always been a debate is what high income earners should pay in their marginal tax rates. So this chart shows the history of what the highest tax bracket has been. And from about 1940 to the 1980s, this was between 70 and 90%. And right now, 37%, obviously, is much lower than that.

And we know that with this revision in 2026, this 37% bracket is going to go up to 39%. So there’s going to be a slight increase in a couple of years. And that’s bearing that there’s no tax changes. There’s been a couple of proposals in the past couple of years have not gotten passed. So, bottom line, we don’t know what taxes will look like in the future, but they’re going to increase in a couple of years as well as just historically, tax rates are low right now. And with Social Security, Medicare, money that was printed in Covid, it’s almost inevitable that taxes will most likely be higher in the future.

So what a Roth account does, if this shoots up, and let’s say we go back to these tax rates that we saw in the 1950s, 1960s, any money that’s in the Roth account, it doesn’t matter because you’ve already paid the taxes. So if tax rates go up, all the money in the Roth is tax free. It’s irrelevant to your planning. Second thing we want to look at is what the difference is. So just the power of tax free accumulation in account. This is an example of a million dollars invested for 20 years growing at 8% per year. We’re going to use the highest. If you’re in the 40% tax bracket, a million dollars growing in a taxable investment account. So you’re paying capital gains taxes are between zero and 20%. That grows to about two and a half million dollars.

If that same million dollars is growing by 8% in a Roth account, inside a tax free, you’re paying zero capital gains taxes. It grows to about 4.6. So about a $2 million difference over 20 years just from compounding tax free accumulation. All that being said, what Roth does, it does a couple of things. But number one, we’re never going to pay taxes on that count again. Under current tax law, that could change. Our belief is that money that’s in a Roth is not going to be taxed. What they could do is just change. If you ever. Maybe in the future, you’re not allowed to do Roth conversions or Roth contributions, but if the law changes, what’s in the Roth most likely will be grandfathered in. But again, that could change. That’s all subject to legislation. Risk a couple of things, though.

Number one, we avoid future taxes with the Roth. So if tax rates go up, doesn’t matter because you haven’t paid any taxes. Number two, one of the biggest things is rmds. So anything in a pretax account depends on your age. But with the new legislation, most people the age of 75, anything that’s in a pretax IRA, you’re going to have to start taking distributions out of this because you’ve never paid your taxes on that money yet. A Roth account has zero. A Roth IRA has zero requirement of distribution. So why this can be problematic. Number one, it can bump you up in your tax rates in retirement, so you get hit in higher tax rates, plus your Medicare surcharges based on taxable income in retirement. Second thing, this is called the sequence of returns risk.

And so you could be forced to sell money while the market’s down and take a distribution because the government is mandating it. Whereas a Roth account, you don’t have to do that because there’s no RMD. So you have total autonomy and control over when you take the distributions. So, first thing is avoid future taxes, tax accumulation. Second thing, no requirement distributions. And then the third thing is this all is tax free to beneficiaries. So anything in a Roth IRA, no taxes on distribution to a beneficiary. With the new stretch IR rule, beneficiaries have ten years to take this money out, but they’re not going to pay any taxes. Just has to be out of the account in ten years. So all of these things, the biggest thing there is a lot of tax savings.

The biggest thing, a lot of our clients like the autonomy and control over not being forced to take money out of a Roth account. So, back to logistically how this works. If your income, I’m going to use the highest tax bracket for simplicity here. Let’s say your income is 700,000 a year, and that’s going to put you in the 37% tax rate. If you did $100,000 Roth conversion, that gets tacked on your income that year, and your income now is 800,000. So, again, like we said at the beginning, you pay 37,000 federally and state taxes for Roth conversions. Depends on the state you’re in. Pennsylvania does not tax state Roth conversions, but you have to do your homework depending on what state you’re in. But that shows up as income. But then again, the money in that account never pay taxes again.

And a common question we get asked is, will taxes be lower? When I’m in retirement, I have less money coming in. But there’s a couple of things we want to point out. Number one, future tax rates are a huge question mark. Like we already mentioned. They’ll probably be our opinion, they’ll probably be higher in the future. So we’re limiting that. Number two, even if you’re not taking distributions, if you’re a high income earner, you’re going to have income coming in through Social Security, capital gains or dividends from investment account that shows up as income. You could have part time income. You could have private investments. That could be anything from real estate, private equity, et cetera. All of these things show up as taxable income, and then your RMDs get taxed on top of it.

So you may be spending less money in retirement, but all of these things could force you into a higher tax rate. And so the more that we have in Roth, we can avoid a lot of these and avoid the highest tax brackets. So a good rule of thumb is we want about a third of a client’s assets in Roth at the time of retirement. So, one, just example. Let’s just say you have $10 million. Ideal breakdown here. Real example, they probably have a good portion in a pretax IRA. I guess the ideal scenario here, let’s just say we would get 4 million into a Roth. We would have, let’s say probably 3 million is in an investment account, and then that leaves 3 million in an IRA. Obviously, the more money we could get over here, the better.

But a lot of this depends on goals. It would depend on income in retirement. It would depend on legacy goals, spending, et cetera. A million variables here. But if you’re positioned with a third in Roth, generally speaking, that will have enough that we can minimize what the RMDs will be and you don’t get crushed in taxes in retirement. So that’s a high level overview of Roth conversions. And when they make sense, we are pretty in favor of them regardless, right now, just because, number one, like we said, tax rates are low and it gives you autonomy and control over when you take the money out. Again, this is totally specific to your situation. In general, most people we’re doing Roth conversions for, but there are certain circumstances where they don’t make sense or you actually will be in a lower tax rate in retirement.

And that’s all case by case, client specific. And that’s the value of working with a financial planner or in a tax professional to figure all this out. If you have any specific questions, feel free to reach out. And if you’re curious if a Roth conversion is right for you, we’re happy to talk to you.