I have seen a warning about this that does not make any sense and I’m wondering if someone can explain it. The warning is that Roth conversions cost money now but won’t pay off until far in the future.
So, for example, if I’m in the 22% tax bracket, and convert $10,000 to a Roth, I have to pay $2,200 in taxes. This means that I now have $7,800 instead of $10,000. I don’t understand where there’s an expectation that I will need to wait a decade to make up that deficit.
Assuming the same tax bracket, it is literally the same amount of money immediately, next year, two years from now, etc. Tax-then-Grow = Grow-then-Tax.
I can only assume that this warning is for people who only intend to use the Roth after Social Security kicks in. But again, it’s always there. There’s no penalty to converting if you do it in the lower tax brackets. ie Converting while still in the 12% bracket, unless you convert so much that you drain your 401K such that you’ll be using your Roth for future 0% tax brackets.
As usual, the answer is “it depends”, everyone’s case is different, depending on your age, your tax bracket, risk, etc.. . For sure, for some (i am one of them) it doens’t make sense.
To visualize it, you need to get an excel and map our a 10 year timeline on two basic scenarios. Option 1 is you keep your 10K in Trad IRA, growing at 8% per year, then pay taxes on the full amounts of withdrawals in future, at your expected tax bracket then.
Option B is you take that 10K, pay 2K in taxes to convert, then grow your now lower base of 8K at 8% for 10 years…then do your withdrawals at 0% tax in future.
Most people dont realize how much more 10K growing compounded at 8% per year vs 8K growing 8% compounded per year means…in a lot of cases, you never make up that 2K loss in base starting point, even though you pay no taxes in the future withdrawals.
you also have to factor in that you will probably be in a lower tax bracket 10 years from now and NOT the 22%. Maybe you’re alreayd assuming that.
i think there are some other limitations also, depending on your current income, that you can’t convert as much. I have to look it up, its been awhile, but that factors in also, that if you earn a fair amount of income today, you can’t convert as much as you can if you are a lower income earner. I think i’m remembering that correctly.
Generally, I think the younger you are, the more beneficial it is to do a conversion. Once you get older, say 55-65, the advantages get less due to what i’m describing above.
Your point looks right to me. The warning to which you are referring is really about psychology, not math. That is, someone with $7800 in a Roth may feel poorer than with $10,000 in a regular retirement account. As you note, if you’re going to be in the same tax bracket in retirement then mathematically they are equivalent. But, you may feel poorer, comparing $7800 post-tax to $10,000 pre-tax. There are other differences with a Roth, and I’m not trying to factor those in. Just keeping the hypothetical on your terms.
Thanks for the thoughtful reply. One point of contention:
Most people dont realize how much more 10K growing compounded at 8% per year vs 8K growing 8% compounded per year means…in a lot of cases, you never make up that 2K loss in base starting point, even though you pay no taxes in the future withdrawals.
Again, it’s exactly the same UNLESS you can figure out how to avoid paying taxes on your 401K.
you also have to factor in that you will probably be in a lower tax bracket 10 years from now and NOT the 22%. Maybe you’re already assuming that.
So that’s where most of the advice comes from. If you’re in a lower tax bracket now, then you convert to Roth to avoid higher anticipated tax brackets later.
For example: if the stock market is bad this year, I can spend cash instead of 401K, and that might keep me in the 12% tax bracket. If the market is up the next year, I’ll sell off stocks from my 401K and maybe replace the roof and buy a new car. Now I’m into the 22%, 24%, or even 32% tax brackets. But I can lower my taxable income by, instead, spending the already taxed money from my Roth.
A Roth conversion is more or less pretty simple: the amount you convert just adds to your ordinary wages for the year, as far as taxes are concerned.
Roth contributions are income limited, but backdoor conversions are not.
If you have a lot in a traditional IRA, it might make sense to leave it alone and then convert some or all of it at a low tax rate during a “gap” year when you’re not working, or when you start retirement.
The other advantage of a Roth as I recall, is there are no required minimum distributions so you can let it sit and grow as long as you want.
I have done a couple Roth conversions in the past during times when I was laid off.
edit: also the note about a lower tax bracket in retirement can also go in reverse. For example if you plan to move somewhere with high taxes like the EU, it makes sense to get as much into your Roth as possible beforehand.
full discloser: I’ve been doing a LOT of research on this lately. Your posts are very much appreciated.
So, what you are probably thinking of are Roth IRA contributions, not a Roth conversion. So with the Roth IRA contributions, you are correct.
With a 401K to Roth conversion, what you are doing it taking money from your 401K, paying tax on it as income, and putting into a Roth account where the taxes are already paid and continue to grow without paying capital gains tax.
The window to do this is typically between when you retire and start collecting social security, so in my case it would be at 57 (using the rule of 55 to draw from my 401K) and 62 (or later). In a nutshell, any opportunity I have where I can convert to a Roth at 12% or lower, I want to take UNLESS I deplete my 401K as a result.
FWIW, I’m still working and am in the 24% bracket, so converting to a Roth now would not be a good idea.
My wife and I are going through this now. As others have said, “it depends.” We are in a rather unique situation in that between our Social Security we will be getting and our pensions, we’ll have around $150,000/year in passive income. When RMDs kick in, our tax bracket is going to be pretty high (22%?) forever. By converting much of my IRA to a Roth IRA over the next few years (before RMD kicks in for me), we’ll be in the 24% bracket for those few years, but then we’ll be at like ~13% for decades, since we’ll have no RMD to speak of, and all our Roth IRA withdrawals will be after-tax.
I’m in the window between when I retired and when I start Social Security, and my wife is retiring in two months (yay!), so our income will be low the next few years. Converting makes sense for us.
Something else that probably doesn’t matter to you (having no kids, right?) is the way inheritance works. When we kick the bucket, our rather substantial IRAs will go to our then-well-established daughters, who will have a short number of years in which to take that money. That’ll destroy their tax liability. With a Roth IRA, they can take it whenever they want and there is no federal-tax liability.
All that said, there is a modest benefit over the first ten or fifteen years. The benefit really takes off after that because of the vastly lower tax bracket you (well, we) will face as explained above.
(one other thing: if you convert stocks during a down turn, your stock holdings will (assumedly) recover tax free. The appreciation in the IRA will be taxed when withdrawn, while the appreciation in the Roth IRA will not. Nice!)
I don’t think capital gains taxes are a thing when held in an IRA or Roth IRA. That’s sort of the point: they grow tax-free. The taxes are due when you withdraw the funds, and it doesn’t matter if they are appreciated or not: you pay tax on whatever is the value you withdraw.
If you want, there is a very sophisticated modeling tool at boldin.com. You can input an incredible amount of financial information describing your situation present and future, including things like modeling the effects of extended market downturns. If you sign up for a free two week premium trial, you can access their Roth Conversion Tool that lets you model anything you want. When you cancel your free trial, they give you another two weeks to “think about it.” You can create multiple scenarios and save them as PDFs (which I did).
I think there’s some special cases for non-qualified dividends, would have to read up on it. In the Roth IRA, withdrawals (in the rare cases where it matters) are first taken from your contributions, then from your earnings after that.
Also note that IRAs don’t pay capital gains taxes but you also can’t harvest losses.
BTW, a tip I just learned is to make sure you don’t pay conversion taxes out of the Roth.
For example: $50K goes to Roth and gets taxed at 12%, = $6,000. If you pay that out of your Roth, you’ll now have $44,000 growing tax free. Pay it out of some other already taxed account, like a brokerage account, cash, etc. That way you keep that $6,000 sheltered from gains taxes. If you run out of cash, you can always just draw it out of your Roth later.
Apparently there’s some default that pulls the taxes out of the Roth that you have to specifically change (I’m still learning this).
Congrats on retirement, BTW! I’m pretty sure you were on ST when I joined 20 years ago. It’s been a ride! (pun intended)
Nearly all our liquid wealth is in our retirement accounts. By maximizing them, we got the most tax-free growth we could. So when we need to pay taxes on Roth conversions, the only place we can draw from is my IRA.
If that’s your situation today, then that’s what it is.
From what I’ve been reading, in retirement you want to have a mix of stocks, bonds, and cash. Stocks give the best long term performance, but can really hurt you in the short term if the market goes bad.
Don’t hold me to this, but I think the recommended mix was something like 60/35/5. I’ve also seen recommendations to have 1-3 years worth of cash on hand (I mean, not physical cash). this allows you some flexibility in how you pay taxes, and how to handle bull markets vs bear markets.
Al just as an FYI. Look into it if you wish. BTW, I’ve found ChatGPT to be a really good source.
It depends on the situation. For myself, Roth conversions make sense. For the bulk of my career I put pre-tax money into my 401K equivalent (I was a fed, so a TSP). The issue is that I now receive a decent pension. As such, it doesn’t take much to put me into the 22% bracket, even in retirement. So I will be doing Roth conversions as 1) I don’t anticipate ever being in the next lower marginal rate and 2) I don’t anticipate the 22% and lower brackets being lower than they are today. 2) is clearly a betting position. With our national debt I just don’t see how these rates can be maintained ad infinitum.
I plan to delay SS until 70, as with the pension it just makes my income too high and I quickly move into higher brackets. To achieve an overall lower tax bill over the next 20 years I want to convert as much pre-tax money as possible before SS kicks in.
If I didn’t have a pension, my math would be completely different. In your example, if I converted $10k at the 22% tax rate, but years down the road I found I could live on an income wherein I stayed in the 12% bracket or lower, today’s decision of converting did end up costing me $1k in today’s money.
I think you misunderstood. By “liquid wealth,” I mean everything that isn’t physical like real estate, cars, jewelry, my violin, etc. We, of course, have a mix of holdings including stocks, corporate and government bonds, and money market funds (so that if everything goes to hell, we have 2-3 years of funds to get us through the downturn without having to sell depreciated assets).
Oh yes, and another reason for my plan for Roth conversions. RMDs would be a killer for me if I don’t convert due to pension and expected high SS monthly check. RMDs would push me into a higher marginal bracket.