Don’t Do a Roth Conversion — Until You Hear This

[00:00:00] Hey, welcome to another episode of Retirement Made Simple. I'm your host, Kevin Lum. I'm a certified financial planner based in Los Angeles, and this podcast is dedicated to helping a million people retire without worry. As a quick reminder, every episode here comes straight from our YouTube channel. So this is just the audio, so you can listen while you're walking, driving, or living your life. Let's dive in.

[00:00:26] If you've spent any time on YouTube, you've probably run across someone modeling how powerful Roth conversions can be. I've done videos on this very topic, and I've showed how Roth conversions can save an immense amount of money in taxes over the course of your life. But today, I want to talk about how Roth conversion models and calculators have the potential to be incredibly wrong.

[00:00:52] Every person who is nearing retirement or is in retirement who has money in a tax-deferred account is hearing the same drumbeat. Convert. Convert. Convert. Convert. From software, from advisors, from other people on this platform. You've even heard it from me.

[00:01:08] And the pitch usually comes with a number. You feed your information into a calculator, and it tells you something like, if you convert a million dollars over 10 years, you'll save $700,000 in taxes over your lifetime or over the lifetime of your heirs. It feels a bit certain, like it's a fact. You are going to save this much money. And then add to that, for a long time, there was a bit of urgency behind it.

[00:01:30] You were told there was a ticking tax time bomb. The 2017 tax cuts were going to expire at the end of 2025. Rates were going to go up, and the top tax bracket was headed back to 39%. So convert now, the thinking went, while rates are still on sale. Of course, that risk is now off the table, at least for a while, because those tax cuts were made permanent.

[00:01:55] Now the message has shifted with the looming debt crisis, rates have to go up. And honestly, I'm sympathetic to that argument. If I had to make a calculated bet, I would guess that future tax rates are going to be higher than current tax rates. Although, taxes have only come down during my lifetime, right? They have not gone up. But ultimately, no one knows what future tax rates are going to be. It's a guess.

[00:02:17] And that leads in to my broader point. That $400,000 tax projection is built on a tower of guesses. Future tax rates, future inflation, future investment returns. It even has to assume when each spouse dies, because that changes everything in the calculations. Change one of those inputs, and the whole answer flips.

[00:02:44] Does that mean the calculators are worthless? Not at all. But you need to understand that the calculations are built on a tower of guesses. So how should you use the calculator? You use it directionally. Does converting lean in my favor or against it, right? If it's showing negative, it might not exactly be in your best interest. If it's showing a $2 million tax savings, it's probably something you should pay attention to.

[00:03:14] But don't treat it as prophecy. Don't treat it as a crystal ball. Don't treat it with certainty. It is human nature to want to solve everything down to the last penny. And the reality is you can't. And pretending you can't is how smart people can get themselves into trouble. Let me give you a couple cases where you should not do a Roth conversion. You're 60, and you have maybe $300,000 or $400,000 in your IRA.

[00:03:39] Unless you're in a very unique circumstance, you're going to spend down that IRA over the course of your retirement. There's very little reason for you to convert. You probably, based on very generalized assumptions, should skip doing a Roth conversion. Here's another scenario. You may have a significant tax-free account, but you plan on spending your money in retirement. You're like, you know what? I am going to spend what I have saved.

[00:04:05] In reality, you can accomplish much of the same result as a Roth conversion by just spending to the top of your tax bracket. Ultimately, Roth conversions are about you choosing the tax bracket that you withdraw money from your tax-deferred account at. And if you don't, eventually that account is going to continue to grow and can cause really large RMDs later in life. Now, one fallacy I see, and I'm going to take a quick detour, is that people say,

[00:04:32] well, I've run the calculations on a $2 million account value. The RMDs on $2 million at age 75 aren't that bad. The problem is you're running that calculation at age 60. If that account grows at a fairly rapid clip over the next 15 years, you don't have a $2 million account. You have a $4 million account you're doing RMDs on. And if that account continues to grow and continues to outpace your spending at age 85 or at age 90,

[00:05:01] now you have a significantly larger account, and that RMD can get quite large. So your RMD is not just the amount you have to take on your account balance today. It's on your future account balance value. And so you need to make sure you take that into account. But returning back from my detour, my general point is you can either do a Roth conversion to control your tax brackets, or you can just spend to the top of the tax bracket. You accomplish the same goal of doing Roth conversions by spending to the top of your tax bracket.

[00:05:31] So second reason you shouldn't do a Roth conversion is if you're going to spend significantly from your tax or from your tax-ferred account. Third, if you're going to give everything away to charity, right? You're a very charitable person. You have significant assets. You can effectively use QCDs, charitable qualified distributions, which you can start doing in lieu of RMDs at $70,500 up to $100,000 to offset most of the RMD pain. So if you're a very charitable person and you plan on giving away most of your money,

[00:05:58] you probably shouldn't do a Roth conversion, or at least it's not as much of a slam dunk. Many of you watching this aren't in any of those categories, right? You have a decent amount of money in your IRA. You have a decent nest egg in your IRA, and you're not going to spend it all because you're fairly frugal, and you're not going to give it all away. Many of you watching are in a category where it makes sense to do Roth conversions. So let me tell you how to do Roth conversions without owning a crystal ball. First of all, stop asking how much should I convert over the next 30 years, right?

[00:06:28] Like you want directionally to understand what bracket you should convert to. It's what you use the software for. But you're never really sure how much you should convert because there's so many unknowns. How much the market's going to grow, what tax brackets are going to be. A lot of that's an unanswerable question. Instead, the question becomes, how much should I convert this year with the year that is facing me, the one that's sitting in front of me? The software can help you dial in the high-level plan, that overview.

[00:06:55] Again, it's built on a pile of guesses or a tower of guesses. But Roth conversions are best done on a year-by-year decision. So if you're in this place, you're thinking about doing Roth conversions, here are some of the things you should consider. First, are you trying to stay inside of a specific tax bracket? What is that bracket? Is it the 10%, the 12%, the 22%, the 24%?

[00:07:22] What bracket are you trying to stay inside of? And depending on how much you have in your tax-deferred account and your overall plan, that's going to drive it. There isn't a perfect Roth conversion tax bracket. I'm sorry to break it to you, but it depends on your situation. So first of all, are you trying to solve to a particular tax bracket? Second of all, are you trying to stay under the IRMA threshold? Are you trying to stay under threshold one or threshold two? What are you trying to do around that? Again, it's based on your particular situation.

[00:07:52] But in 2026, when I'm recording this video, the moment your income crosses a certain threshold, you trip a surcharge on your Medicare premium. It's a cliff. One dollar over it, and the full surcharge hits. Now, here's the interesting thing. It's a two-year look back. And so you don't even realize it at first. Like, you trigger the IRMA surcharge and nothing happens. You're feeling pretty good about yourself. And then two years later, out of the blue, you get this notice saying, hey, you get to pay more for the exact same coverage.

[00:08:20] So ask yourself, am I trying to solve to a particular IRMA surcharge level? Am I trying to stay under any surcharge at all? Or maybe I just want to trigger the first level, right? What are you trying to do? Here's number three. Are you retiring before 65 and buying your own health insurance to the marketplace? One of the things you've got to weigh is, do I solve for the ACA subsidy? Or do I solve for the long-term tax savings? And the problem is, it's a really hard calculation to run. Because on the one hand, depending on where you live,

[00:08:47] it can be a couple thousand dollars in your pocket guaranteed each month. Whereas the Roth conversion projections are, as I've said over and over again, are built on a tower of guesses. We just don't know. It could be a much better move doing a Roth conversion rather than taking the subsidies. But there is a chance that the tax law is going to change or your account's not going to grow very fast. And you would have been better off taking the subsidy. Now, I want to take another detour. And I want to talk specifically to those of you who are thinking

[00:09:16] about solving for the subsidy. But one of the things I see is that people have more than enough money to retire. They're going to have a very comfortable retirement. They'll have everything that they need covered throughout retirement. But they end up solving for the ACA subsidy. They keep their income so low that they can't actually do the things they dreamed of doing in retirement because they're essentially trying to live near the poverty level. And so they're significantly underspending to get this subsidy, which is great. But their plan still works without the subsidy.

[00:09:45] And yet, in exchange for that subsidy, they are giving up some of the best years of the retirement. It is not always the best option to optimize for the ACA subsidy. And so you really want to think long and hard if you are in that situation. Now, some people, it really helps make your plan work. And you should optimize for it. But other people, it might not make sense. But what you need to understand, if you are in the case where it actually could help your plan a lot if you got the subsidy,

[00:10:12] you need to understand that if you go $1 over that 400% of the poverty line, you can lose every penny of the subsidy. And that can be a big hit. A conversion. Without proper tax planning, it can push you over that level. And you might not even realize it. Number four, are you trying to protect or trying to solve for the senior deduction? There's a $6,000 deduction on the table for each senior over the age of 65. Once your income climbs past a certain level,

[00:10:41] if you convert too aggressively, you can end up erasing the deduction. Now, it might, underline might, highlight might, make sense to do a conversion. But it's a year-by-year decision. And you need to understand directionally where you're headed. And then you need to look at this year's numbers and dial in your tax plan. Number five, and simplest of all, how much cash, and this is a big one, how much cash are you willing to spend on conversion taxes this year?

[00:11:09] Because it's all fun and game until the tax bill arrives. I've had multiple clients. We've run through the numbers. We've talked about how much it's going to cost. They're okay with it. But then when that tax bill arrives, they'll message me and be like, I know you told me it was going to cost X amount of dollars, but boy, I hated paying that bill. And so if you're thinking about doing Roth conversions, you want to think about not just the big number on the screen, but each year you want to dial it in and think about all those different variables

[00:11:36] and make sure you're taking them into account as you build your Roth conversion plan. And here's the part a calculator often doesn't show. A Roth conversion doesn't just cost you taxes. It can increase the sequence of return risk, right? Think about what a conversion is. It is a voluntary withdrawal. You're choosing to pull money and trigger a tax bill you didn't have to trigger this year, which can increase your sequence of return risk, right? Think about this.

[00:12:04] You convert aggressively in your early 60s, and the market drops in the exact same years you're doing the conversions. Now you might have to be selling at a loss to pay the tax bill in addition to selling at a loss to fund your retirement expenses. That money is gone from your portfolio at the worst time possible when you need to keep your money invested so it can recover. And what you've done is you've shrunk your base that has declined back, and that can end up triggering a sequence of return risk,

[00:12:31] and you did it to yourself because you're trying to save money on taxes. Now, there are ways to handle this to where you can mitigate that risk and you can be very smart about it. And so ultimately, I'm not too concerned about the sequence of return risk if you understand what you're doing. But if you're just out here watching videos and saying, oh, this guy on YouTube says I could save a million dollars, and I used his software, and it says I could save a million dollars too, I'm going to do a Roth conversion. But you don't fully understand what you're doing,

[00:12:59] it can end up causing you a lot of problems. And so you want to be strategic and dial in your plan every year and making sure you're protecting yourself from things like sequence return risk or making yourself lose tax deductions you didn't realize you were causing yourself to lose. If you're being strategic about it, it's often okay and often smart to give up that deduction for a couple of years, but you need to understand what you're doing and why you're doing it. Now, I'm not telling you not to do Roth conversions. I love Roth conversions.

[00:13:28] We do Roth conversions probably for 75% of our clients. I think there are genuinely great reasons to do conversion. Now, as I said, the majority of people we work with do Roth conversions, but it's not a magic bullet, and it needs to be optimized and dialed in every year. It's not a set it and forget it type of thing. You want to make sure you know what you're doing. Now, there are a few reasons you really want to do Roth conversions. One of the biggest ones, I've talked about this in detail in other videos, but it's the widow's penalty.

[00:13:58] When one spouse passes away, the survivor starts filing as a single filer and the tax brackets, they compress. The IRMA thresholds compress. Income that was perfectly comfortable for a couple suddenly gets taxed at a higher level. Converting while you're both still here can take real pressure off the survivor later, right? That's a great reason to do a Roth conversion. Another great reason to do a Roth conversion is you're going to have a significant amount of money that you want to leave to your heirs,

[00:14:27] and you want to leave them the most tax-efficient portfolio possible. One of my clients emailed me this week, and he just inherited an inherited IRA. He's like, this is really complex to deal with. I don't want to leave that sort of complexity to my kids. Under current law, when your family inherits your IRA, they have to drain it within 10 years, often during their own peak earning years, which pushes them into an even higher tax bracket. So if you're planning on leaving money to your children,

[00:14:55] and if you've done a great job raising them, which I'm sure many of you have, they're going to be in their highest earning years at the moment they receive their inheritance. Roth conversions become a really powerful tool in helping money pass your heirs in a more tax-efficient way, right? Are you doing conversions for yourself, or are you doing conversions for your heirs? And then one more thing to note as we kind of wrap this up is that there are other tools in your toolbox, right? If you're charitably inclined, qualified charitable distributions after you reach 70 and a half

[00:15:25] let you satisfy your required minimum distributions up to a certain amount instead of taking RMDs. So you don't have to take RMDs. You can just use the QCD in lieu of it, which can help reduce the tax bill. And QCDs can make Roth conversions less needed. So here's the thing. The calculator isn't useless. It's an excellent directional tool. The problem is, is sometimes those calculations are oversold. Use it for direction, but ignore the precise dollars,

[00:15:55] or at least don't think of it as a guarantee. Because as I've said multiple times in this video, it's built on a tower of guesses. So here's how I want to end. And if you watch my videos, you're going to feel like it's a broken record. In fact, just remember this one part, and you never have to watch another video again. Retirement planning is personal. It needs to be built around your particular situation, your life, your goals, your portfolio. And what often happens is you watch a YouTube video, or you read an article,

[00:16:23] or you hear some pitch, and it seems like this magic tool that can make your taxes all disappear, and that everyone should do this thing. And often it's just a sales pitch. And if you don't fully understand what you're doing and why you're doing it, you can end up causing yourself more trouble and ultimately costing yourself a lot of money over the long run. You want to be sure you're strategic, that you are using software, and you're using tools directionally, but then you are dialing in your plan each and every year

[00:16:51] that's tailored to your life and your situation. Hey, thanks for listening. If you enjoyed this content, if you'd do me a favor and just leave a review on whatever podcast app you're using, Apple or Google or Spotify. And also you can find us on YouTube. Just search Foundry Financial or Retirement Made Simple. You should be able to find us by searching both. And then you can find our website at foundryfinancial.org. Thanks for listening.