Skeels Cygan: 10 reasons not to do a Roth conversion

EDITOR’S NOTE: Over the next three months, Donna Skeels Cygan will look at the pros and cons of Roth conversions.

Roth IRAs and Roth conversions offer many benefits for investors. But they are not for everyone. Today’s column will focus on the reasons not to do a Roth conversion. My next column in July will cover strategies and the many benefits of Roth conversions, and strategies to consider for Roth conversions will be the topic of my August article.

The history

Let’s start with some basics. Traditional IRAs, called individual retirement accounts, were introduced in 1975. These were a new retirement savings vehicle that allowed investors to contribute to an IRA, and take a tax deduction each year they contributed. The money grew tax-deferred — growing and compounding through working years. The accounts were intended to provide a nest egg for retirement. At retirement age (after 59½), investors could take withdrawals from the account, and all withdrawals would be taxed as income.

In the late 1970s, similar plans became available through private-sector employers. Termed 401(k), the plans are similar to traditional IRAs, allowing an employee to defer a portion of their paycheck into the plan, and employers often provide a partial match for the employee’s contribution. Similar plans through nonprofit and government entities — termed 403(b) plans — became available in the early 1960s.

Although 401(k) plans and 403(b) plans have some unique differences from traditional IRAs, the tax deferral provisions — with all withdrawals during retirement being taxed as income — are the same. In recent years, 401(k) and 403(b) plans have started allowing in-plan conversions to their Roth counterparts.

In 1986, new rules were enacted that required investors to start taking annual withdrawals, called required minimum distributions, or RMDs, at age 70½. The starting age later increased to 72, then 73, and it will be age 75 for persons whose birthdates are after Jan. 1, 1960.

In theory…

As originally planned, the traditional IRA was brilliant. Most retirees assume they will be in a lower tax bracket when they retire, and the retirement account will provide money to pay expenses during retirement. The tax deduction for the initial contribution and the tax-deferral for many years are rich benefits, justifying the income taxes that are triggered when withdrawals begin.

Due to a strong U.S. stock market during the past 30 years, the size of retirement accounts for many investors has grown quickly.

The plan goes awry for investors who embraced the traditional IRA and funded those plans each year to the maximum allowed. The maximum contribution allowed for a 401(k) or 403(b) in 2025 for someone over age 50 is $31,000, and a new catch-up provision allows up to $34,750 for people age 60-63. The maximum amount allowed in 2025 for employer and employee contributions is $70,000. Some small-business plans allow even more.

So, what’s the problem?

The problem is that many investors have traditional IRAs — and 401(k) and 403(b) plans — that have grown to over $1 million. Fidelity Investments reported that over half a million 401(k) accounts contained over $1 million in 2024.

Many people in their 50s or 60s are looking forward to retirement and are now realizing that these large accounts will trigger large RMDs and very high taxes, termed a “tax bomb.”

When they consider the Social Security benefits they expect to receive, plus a possible pension and investment income, they discover they will not be in a low tax bracket during retirement. They also realize they may not need the large RMDs for living expenses.

That’s where Roth conversions can help, because Roth conversions transfer money from a tax-deferred account into a tax-free account. Roth IRAs do not have RMDs, and they offer significant estate planning benefits if you want to leave the account to children or grandchildren.

However, taxes must be paid each year on the amount that is converted. Roth conversions, in essence, are pre-paying the taxes to get the money into an account that will be tax-free going forward.

But Roth conversions are not for everyone.

10 reasons not to do a Roth conversion

1. Your traditional IRA, or 401(k) and 403(b) plans, are not large, and you do not expect your RMDs to be too large. In addition, you anticipate needing the money for expenses during retirement.

2. You plan to leave your traditional IRA to charity when you die.

3. You expect your future tax rate during retirement to be less than your current tax rate.

4. You do not have money in an after-tax account (such as a savings account or a taxable brokerage account) to pay the taxes on the amount you convert.

5. You expect your children or grandchildren to be in a lower tax bracket than you are if they inherit your traditional IRA.

6. You believe Congress will change the rules and tax Roth IRAs in the future.

7. You hate the idea of paying any income taxes sooner rather than later.

8. You are age 63 or over, and suspect a Roth conversion may trigger income-related monthly adjustment amount, or IRMAA, surcharges (on Medicare premiums beginning at age 65 but based on income two years before, starting at age 63).

9. You are receiving Social Security benefits, and suspect a Roth conversion may increase the amount of federal taxes you will pay on your Social Security income, trigger New Mexico state income taxes on the amount of Social Security you receive or trigger net investment income tax, or NIIT. These are tax-planning issues that must be considered.

10. A Roth conversion sounds too complex. You’ll take a wait-and-see approach.

For most investors, the traditional IRA will continue to serve them well during retirement. For investors who have accrued a very large traditional IRA, there are tax and estate planning concerns.

The tax man cometh (via the RMD)

The amount of the RMD starts at 3.77% of the balance in the account at age 73 (and 4.06% at age 75 if you are born in 1960 or later). The withdrawal percentage increases as you age, and is currently 4.95% at age 80, 6.25% at age 85 and 8.2% at age 90.

If you are age 73 and you have $500,000 in a traditional IRA, or 401(k) or 403(b) plans, on Dec. 31 of the prior year, your RMD at age 73 will be approximately $18,850. That is not excessive and doesn’t seem like it would cause tax problems.

Let’s look at another example. Let’s assume you are age 50, you have $500,000 in a 401(k), and you are contributing the maximum amount to it each year.

Without any contributions — just with the Rule of 72, which states the value will double in 10 years if you average an annual return of 7.2% — the account will double to $1 million by the time you are 60, and will double again to $2 million by the time you turn 70, and $3 million by age 75 when you must begin taking RMDs. This would result in an RMD at age 75 of $121,800 ($3 million x 4.06%).

However, you’re contributing to the account each year, so it could conceivably double in six years, causing it to be almost $8 million by age 74, just before you must start taking RMDs. If the current tax laws do not change, the RMD would be $324,800 ($8 million x 4.06%) when you are 75 and must take your first RMD. Yikes! That’s a tax bomb!

What about my beneficiaries?

No. 2 above also needs an explanation. Because traditional IRAs, as well as 401(k) and 403(b) plans, are tax-deferred during your working years, taxes are due during retirement. The IRS requires that someone pay the taxes, unless you leave your IRA to a charity. Most people want to leave their traditional IRA to a loved one, so that person must pay the taxes.

If you leave your traditional IRA to a child or grandchild — or any non-spouse beneficiary — that person will pay taxes on the full amount. The Secure Act 1.0 passed in December 2019 requires the full amount to be withdrawn (and taxes paid) within 10 years after your death.

If you leave a Roth IRA rather than a traditional IRA to a non-spouse beneficiary, the full amount must still be withdrawn within 10 years after your death. However, there are no taxes due.

Roth IRAs offer significant tax and estate planning benefits, which I will discuss in next month’s column.