6 Reasons NOT to Convert to a Roth

why did your strategy cause me to lose money that's how an email started that I received last week from someone who' watched one of my videos about Roth conversions and then run their own scenario using right capital and when they modeled at Roth conversion it caused them to have less money not more money Roth conversions are a powerful tax minimization strategy in retirement but there are some instances when a conversion could do more harm than good so in today's video I'm going to walk through some of the reasons you shouldn't do a Roth conversion but first my name is Kevin Lum I'm a certified financial planner and this channel is dedicated to helping a million people retire without worry now as you know if you've watched any of my videos roth conversions can provide tremendous tax savings in retirement often over a million dollars but there are some times when doing a conversion can do more damage than good so just a second we're going to look at some of the reasons you should not do a Roth conversion but before I do that just quickly if you are new to conversions a Roth conversion is the process of transferring money from a pre-tax retirement account into an after tax Roth IRA so an example of a pre-tax retirement account would be a traditional IRA a traditional 401K SEP IRA simple IAS Etc now interestingly inherited IAS while technically a pre-tax retirement account cannot be converted into Roth IRAs I have another whole video talking specifically about inherited IRAs now there are no limitations on Roth conversions if you have a million dollars in a pre-tax traditional IRA you can technically convert the entire million dollar tomorrow into a Roth IRA if you wanted to and the benefit is that the converted dollars are going to grow tax-free forever in your Roth IRA you won't have to worry about rmds at age 73 or 75 and for most people your heirs will inherit a pot of money that's going to be completely taxfree and so often doing a Roth conversion can save you a million plus dollars in a tax adjusted portfolio over your life so what's not to love well there are a few reasons you might not want to do a Roth conversion the first reason and I'm going to admit this is not the most technical reason but you just don't want to Roth conversions aren't for everyone and that's fine some people simply cannot stomach paying a large tax bill upfront they would rather spread their withdrawals over say 30 years and pay taxes over 30 years rather than having a giant painful tax bill spread over 5 years because if you've run your own conversion numbers you can know that you will often have a very large tax bill up front and that's going to reduce your cash on hand which for some people makes them feel more insecure so even if all the numbers say it's the best decision and puts you in a more secure financial position for some people having to take two three $400,000 out of the retirement savings UPF front to pay for these conversions is just more than they can hand handle now will the decision not to make a Roth conversion potentially cost maybe a million dollars over your life maybe but the truth of the matter is finances are personal decision you get to decide you don't have to explain your decision to anyone the second reason you shouldn't do a conversion and honestly this is one of the biggest reasons that I see is that you don't have the cash outside of your retirement account so your traditional IRA you don't have the cash to pay for the taxes on the conversions and this is one of the biggest issues that hurts the long-term success of your Roth conversion if you have to pay for the conversion out of your IRA or out of your tax deferred account depending on your longevity and your investment strategy you may actually reduce the long-term value of your portfolio even on a tax adjusted basis let me show you an example using right Capital so here we are back at Phil and Clare duny again uh this time actually I believe I have that they're both 64 years of age and they both have $500,000 in their Ira so a million total 500,000 in Claire's Ira $500,000 in Phil's Ira so the question is does it make sense to do a Roth conversion so let's go over here to the tax Center let's look at distributions we're going to see doesn't makes sense to a Roth conversion well here we can see that doing a Roth conversion Phil and CLA have a million dollars in their Ira they seem like they'd be a great candidate to do a Roth conversion but the Roth conversion at least at the the income brackets it's set at is going to cost almost $923,000 in a tax adjusted portfolio now we're not at playing with the withdrawal sequence at all yet we'll do that in a minute but so you can see converting the 24% tax bracket not a smart idea what about the 22% tax bracket Now it only costs them 365,000 in a tax adjusted ending portfolio there's a little bit of benefit at 22 or at the 12% tax bracket but just barely and $22,000 over a 30-year time Horizon probably still isn't worth doing that conversion so then you could take them down to the 10% it's $48 more so why isn't the Roth conversion saving Phil and Clair money if you watch the last video you you know it's could often be a million dollars in tax savings so what's the issue here well the issue is is that Phil and CLA don't have any cash outside the taxable account and so they're having to pay for the conversion from inside of their traditional IRA so it's taking money from the traditional IRA that could be invested or that could be converted and it's having to pay the taxes so if we go over here and look at the comparison we see that the value of the portfolio let's take it up to the 22% tax bracket so you can see here that the ending value of the portfolio without a conversion is 1.7 almost 1.8 million the total portfolio value is uh with the conversions 1.4 so they end up with less money at the end but then let's come up here and see the federal taxes paid so by doing the conversion they save almost $300,000 in federal taxes so $500,000 as opposed to $200,000 so there is a tax savings um but that reduces the portfolio value because they had to pay taxes up front so now they have less money invested whereas if let's come over here let's go to their account let's give them an extra let's in this taxable account let's give him half million so now let's go back over to the tax Center let's look the same now we see that that conversion at that level is going to be $300,000 more in tax adjusted portfolio we come down here let's play with the withdrawal sequence as well now converting at the 12% tax bracket or 15% tax bracket when the current tax cut sunsets along with the right withdraw sequence can mean almost $851,000 more in tax adjusted ending portfolio than a strategy without doing a conversion the third reason you should consider not doing a Roth conversion is if you plan on leaving a large chunk of your assets to a charity because if you're going to leave a large chunk of your money to a charity most Charities are going to be tax exempt so it would make sense to convert a traditional IRA pay the taxes and then leave the Roth IRA to a charity since the charity receiving these assets will not pay taxes for selling the assets and for withdrawing them prepaying taxes by converting to a Roth IRA essentially means the charity would get less money not more money and in addition Once you turn 70 and A2 you can begin taking qualified charitable distributions from your account up to $100,000 a year and once you're required to take rmds those qcds or those charitable qualified distributions can count as your rmd so if you're charitably inclined and plan to do a Roth conversion it might make sense to leave a portion of your savings in your IRA and simply take a qcd to cover your future rmd so that's another thing to consider if you are planning on leaving a portion of your tax to ref accounts to charity you don't want to do a Roth conversion on those dollars the fourth reason you might not want to do a conversion or at least you want to delay doing your conversion is if your income and your tax rate will drop later in retirement now this isn't always the case sometimes it actually is better to just go ahead and pay slightly higher taxes and get everything converted but this is especially true if you're going to retire to a low tax state so if you're a resident of California and you plan to retire to Florida a Roth conversion may not make sense at least until you're a resident of Florida California has a very expensive income tax rate whereas Florida has no state income tax and so it might make sense to delay the Roth conversions until you're a resident of say Florida but it's not just Florida there are 13 states that either don't have income tax or they don't tax distributions from your tax deferred accounts like your 401k and your IRA so you might want to delay starting the conversion process until you've moved and become a resident of the lower tax states fifth reason you might not want to do a Roth conver version is if you have a shorter than average life expectancy that's going to mean fewer years of potentially large rmds and this is especially true if your erors are in a lower tax bracket so if your aors are in a lower tax bracket it doesn't make sense for you to convert at a higher tax bracket and then for them to inherit the money tax-free would be better for them to inherit a larger pot of money than they can pay for the conversions or they can pay the taxes at a lower tax bracket but you need to analyze your unique situ situation the next reason you might consider not doing a Roth conversion is Shadow taxes or fees right herur charges and qualifying for ACA subsidies are something you want to take into consideration it's not necessarily a reason not to convert in many cases it could make sense to pay a few extra thousand dollar in fees to save hundreds of thousands of dollars in the future by taking Roth conversions and those calculations should also be included in your timeline right when should we start conversions how long should we do conversions CU then you want to dial everything in just right and a tool like right capital is really helpful for helping you see the the impact of a Roth conversion but often you're going to have to do some manual calculations to figure out actually it only makes sense really for me to do three years of Roth conversions because I'm going to do a qcd on some of the money in the IRA and I don't want to trigger an Irma sech charge or I need to qualify for the ACA subsidies and so you can start with a tool like you know new retirement or WR Capital but then you may need to do some manual calculations or work with your advisor and the thing I hope you take away from this video is you need to carefully weigh the pros and cons of your situation before committing to a Roth conversion because once you do a Roth conversion it's over there's no going back and if you have an advisor this is where you want to use them and if they dismiss your interest in a Roth conversion find a new advisor who will do tax planning I've talked to so many people over the past few months after releasing the video on Roth conversions who told me their advisor told them don't do a Roth conversion don't worry about that doesn't make sense and that may be true but if they're not willing to at least run the numbers for you you want to find a new advisor Roth conversions can have huge tax savings when implemented strategically over time but they also have the potential to backfire now if you want to play around with the numbers yourself I'll put a link in the show notes so you can get access to right Capital limited access to right Capital but you'll be able to use the tax Center and kind of play Ra Roth conversions but as I said earlier like right capital is only going to take you so far you're going to need to do some manual calculations and most likely you'll want to talk to a financial adviser who specializes at that now also if you haven't watched my other video if this is the first video maybe you've ever seen of mine you haven't watched my video on the power of a Roth conversion you can watch that now

Channel: Kevin Lum, CFP®

Views: 129,985

Keywords: retirement planning, Roth conversions, tax planning, traditional IRA, tax implications, retirement savings, tax efficiency, retirement tax strategies, retirement withdrawals, retirement tax planning, retirement portfolio, retirement advice, retirement mistakes, retirement tips., retirement tax implications, retirement income strategies, retirement planning mistakes, Roth IRA conversion, retirement tax efficiency, retirement withdrawal strategies, retirement tax tips

Id: jnebH39pvO4

Length: 11min 46sec (706 seconds)

Published: Sat Apr 06 2024