Tax Experts Explain When Roth Conversions Stop Paying Off

A Roth conversion can be a useful retirement-planning move: you pay taxes now in exchange for tax-free income later. But depending on your income, age and timing, converting too much or converting at the wrong moment can work against you.

I asked tax experts to break down when Roth conversions no longer make financial sense.

What a Roth Conversion Does

A Roth conversion moves retirement savings from future taxable income into tax-free growth, but it also creates an immediate tax bill, according to Paul Gaudio, certified financial planner (CFP) and director of Crestwood Advisors Group LLC.

In general, a Roth conversion is successful “when the taxes paid on the conversion are less than the taxes that would have been collected later,” said Scott Maurer, certified IRA services professional (CISP) with Advanta IRA.

When Roth Conversions Tend To Work Best

The strategy often works best during periods of lower income, when taxes are temporarily reduced and there is still time for long-term growth, Gaudio said. That can include early retirement, before Social Security or required minimum distributions begin.

Retirees may have a few years when taxable income is lower, which can make it a good time to convert part of their savings, added Andrew Gosselin, certified public accountant (CPA) and senior contributor at Save My Cent.

“[When] there are still a significant number of years for the investments in the account to grow,” the tax savings can compound, Maurer said.

When Roth Conversions Stop Making Sense

A Roth conversion stops being advantageous when the taxes paid now outweigh the benefits that may come later, Gosselin said.

Because conversions create an immediate tax bill, they tend to lose value “when the individual does not have enough money in liquid accessible non-retirement accounts to cover the tax liability of their conversion,” Gaudio explained.

If retirees have to pull extra money from an IRA just to pay the taxes, they give up part of the benefit, Gosselin said.

When Conversions Can Raise Taxes Or Medicare Costs

Converting too much in one year can create unintended consequences, including moving you into a higher tax bracket, increasing your tax bill, raising Medicare premiums or reducing other tax benefits, Gosselin explained.

Gaudio said the tax bracket matters: “If we expect the client to be in the 24% tax bracket throughout their retirement, then we probably would not recommend a conversion amount that puts them into the 32% tax bracket.”

He also said it is important to account for possible Medicare premium increases by keeping IRMAA brackets in mind.

When There Is Not Enough Time For The Strategy To Work

The main advantage of a Roth conversion comes from years of tax-free compounding, Gaudio said. In other words, “the more time you can give your Roth IRA to grow and compound, the better.”

That means conversions later in life may produce less tax benefit, Maurer noted, “because there may not be as many years for the IRA investments to create returns.”

When You May Need The Money Too Soon

Conversions can backfire, Gaudio said, especially “when the spending goals of the individual makes it likely that they will need to access much of their Roth IRA funds to support future living expenses.”

The IRS rule also matters: converted funds can be withdrawn tax-free only five years from Jan. 1 of the year of conversion. That timing should be part of any conversion plan, Gaudio said.

The Biggest Roth Conversion Mistake To Avoid

Trying to convert too much at once is one of the most common and expensive mistakes.

“People often think they need to convert a large amount all at once, while in reality, it is usually better to do smaller conversions over a few years,” Gosselin said.

A Roth conversion can be a powerful tool, but only when the timing and tax picture are right.