A Roth IRA Conversion Is Probably A Waste Of Time And Money For Most

If the House Ways and Means Committee has its way, there’s a chance doing a Roth IRA conversion will be no more in 2022 and beyond. Frankly, I’m pretty agnostic to ending our ability to convert our traditional IRAs to Roth IRAs.

To contribute to a Roth IRA in 2021, single tax filers must have a modified adjusted gross income (MAGI) of $140,000 or less, up from $139,000 in 2020. If married and filing jointly, your joint MAGI must be under $208,000 in 2021 (up from $206,000 in 2020).

For those who have a traditional IRA and are now making over $140,000/$208,000, you can currently do a backdoor Roth IRA conversion. You pay taxes upfront so you don’t have to pay taxes upon withdrawal.

As a reminder, you can contribute a maximum of $6,000 to a traditional IRA tax-free. You can deduct the contribution from your current income, which lowers your current federal tax bill. Upon withdrawal, you must pay taxes based on a future unknown income tax rate.

For a Roth IRA, you contribute after-tax money. The money and all future gains are tax-free upon withdrawal.

Why You May Still Not Want To Do A Roth IRA Conversion

When deciding on a Roth IRA conversion the key variable to solve for is your tax rate. If your tax rate is the same when you are contributing to a traditional IRA and when you retire, there is no saving.

Below are the latest federal income tax brackets and rates for single filers, married couples, and heads of households.

Let’s say you are 40 years old and make $65,000 a year. This income level puts you in the 22% marginal federal income tax bracket.

If you invest $6,000 in a traditional IRA and it grows at 8% a year for 20 years, you will end up with $27,965. When you withdraw the money, you decide to withdraw all of it and pay the same 22% marginal federal income tax. Therefore, you end up with $21,813.

On the other hand, if you contribute to a Roth IRA, you have to pay 22% tax on that $6,000 upfront, leaving you with $4,680. If it grows at 8% a year for 20 years, at age 60 you can withdraw, tax-free $21,813. In other words, the results are the same.

If the tax rate is the same, here is the equation that proves contributing to a traditional or Roth IRA is a wash.

Y = A * B.  Re-arrange to A = Y / B.  Or Y = A * B is equal to Y = B * A.  

Forecasting Future Tax Rates Is Key

Some may argue that tax rates must go up in the future to pay for all our deficit-spending today. However, when I first wrote the classic post, Disadvantages Of A Roth IRA: Not All Is What It Seems, eight years ago, people were arguing the same thing. Then Donald Trump came into office and lowered tax rates under the Tax Cuts And Jobs Act.

Therefore, nobody can be sure what tax rates will be in the future. But what we should feel confident about is NOT seeing tax rates go higher for the middle class. Politicians will always depend on the middle class to stay in power. Therefore, politicians will unlikely hurt the middle class through higher taxes.

There are many ways to define the middle class. Given we are talking about income tax rates to determine a Roth IRA conversion, one commonly acceptable middle-class definition is the median household income up to + 50%.

The current median household income is about $69,000. Therefore, the middle-class definition for the country is income up to about $103,500.

Given politicians also have to account for millions of people living in higher cost of living areas as well, a middle-class income can also be adjusted higher.

For example, a family of four in San Francisco is considered “low income” if it earns $117,000 or less. Therefore, in my opinion, a middle-class definition may be considered earning up to $300,000 in the SF Bay Area.

In other words, it is highly unlikely tax rates for those earning up to $300,000 inflation-adjusted, will ever be raised. In fact, President Biden has stated he will not raise taxes for anyone earning less than $400,000. Therefore, $300,000 seems to be a conservative income cut-off point for facing future tax increases.

Your Income Will Likely Be Lower In Retirement Than While Working

We’ve made the argument that household income up to $300,000 will likely not face tax hikes. Now let’s argue why our incomes will likely be lower in retirement. Lower incomes in retirement also correlate with lower tax rates.

On the face of it, arguing your income will likely be lower in retirement than while working makes sense. After all, by definition, you’re not working in retirement! Most of your income will come from Social Security, a pension if you’re lucky, and investments.

Of course, the modern-day retiree often works on side hustles that keep them busy. Therefore, there could certainly be some extra active income coming in.

But for the most part, most retirees will just live off what they’ve saved and what the government and maybe their company have promised them. In a low interest rate environment, generating more investment income is more difficult.

Retiree Example #1: The Luckiest Ones

Let’s say you’re lucky enough to amass $1 million in your IRA at age 67. I write “lucky” because only ~12% of Americans have $1 million or more saved for retirement, according to a 2020 TD Ameritrade Survey. Who knows the exact percentage, but we can be certain that only a small minority have seven-figure retirement accounts. That said, I firmly believe the majority of FS readers will be millionaires in retirement.

At age 67, you’re also eligible to collect the maximum Social Security benefit of $3,011. This amount comes out to $36,132 a year and will go up with inflation. Yet another lucky break, even though you contributed to the system for many years.

How much should you withdraw from your traditional IRA to fund your retirement lifestyle? You plan to live a comfortable lifestyle until age 90. Therefore, you decide that withdrawing at a 4% rate sounds good. You can always adjust the withdrawal rate in the future.

Your total income is now $76,132, $36,132 from Social Security + $40,000 from your traditional IRA. A $76,132 income squarely puts you in the middle class, the Safe Zone where income taxes won’t go up!

Not All Your Income Is Taxable

However, $76,132 isn’t your taxable income. Let’s say the standard deduction of $12,550 per individual and $25,100 per married couple, inflation-adjusted, still exists when you are retired. If so, your maximum taxable income is $63,582.

Further, did you know that your Social Security income isn’t fully taxed? The portion of your Social Security benefits subject to taxation varies with income level. You’ll be taxed on:

  • up to 50 percent of your benefits if your income is $25,000 to $34,000 for an individual or $32,000 to $44,000 for a married couple filing jointly.
  • up to 85 percent of your benefits if your income is more than $34,000 (individual) or $44,000 (couple). 

In other words, even if you are one of the lucky retirees with a $1 million traditional IRA and who can collect the maximum Social Security benefit, your tax rate still likely won’t go up. In fact, it may actually decrease.

For the vast majority with lower incomes, they almost certainly won’t be facing a higher income tax bracket in retirement.

Retiree Example #2: The Lottery Winner

Roth IRAs are most valuable for those with top 1% net worths and top 1% incomes IN retirement. Roth IRAs are also a valuable tool for tax planning for those dealing with a big estate, because the heirs can draw the money tax-free.

The issue is, how many of us will retire in the top 1%? Only 1% or less.

Let’s say you’re a lucky individual making $700,000 a year. You’re in the top marginal federal income tax bracket and are concerned about paying a 39.6% marginal federal income tax rate in retirement versus 37% currently.

Therefore, you decide to do a Roth IRA conversion and pay a 37% rate upfront on the pre-tax contributions you made when you were only in the 22% marginal income tax bracket years ago.

Yikes! This Roth IRA conversion locks in a 15% loss with the potential for only saving 2.6% in federal income taxes in the future.

Top 1% Net Worth Composition Breakdown

After 20 more years of making at least $700,000 a year, you amass a fortune of $15 million. Out of the $15 million, $5 million is in a Roth IRA conversion, $5 million is in after-tax brokerage accounts, $3 million is in your primary residence, and $2 million is in rental properties.

Hooray for having a top 1% net worth, which currently has a minimum net worth cut off of $10 million.

You could only have achieved this net worth by consistently saving 50% of your after-tax earnings and investing the difference. Only a minority of people have such a high saving rate. Therefore, you were really “only” living off about $200,000 a year.

In retirement, your $5 million in after-tax brokerage accounts is generating $100,000 a year in dividends. While your $2 million in rental properties is generating about $80,000 a year in taxable income. Your total investment income is about $180,000 a year.

Saving rate by income / wealth class

Raising Spending From $200,000 to $300,000

Given life is short, you decide to target ~$300,000 a year in gross spending, or 50% more than during your 20 years of work. Therefore, you decide to withdraw $120,000 a year, or 2.4% from your Roth IRA each year. Your total income is closer to $336,000 thanks to also being eligible for Social Security.

For tax simplicity’s sake, your $336,000 in total retirement income faces a maximum marginal federal income tax rate of 35%, which is still lower than the 39.6% when you did the Roth IRA conversion.

You would need to withdraw closer to $200,000 from your Roth IRA to potentially start paying the same marginal federal income tax rate. But can you really comfortably spend double what you’ve been used to spending for the past 20 years? Doubtful.

Again, to get to a $336,000 annual retirement income requires you to get to a $15 million net worth. Not possible for more than 99% of the population. Please be realistic with your expectations.

For a quick calculation, take whatever you are making now and divide it by 3% and 4%. The result is your likely liquid net worth target necessary to be able to generate a similar level of income in retirement. If you have a similar level of income in retirement, your tax bill likely won’t increase.

Making Up For My Lack Of Roth IRA Contribution

Despite highlighting how doing a Roth IRA conversion likely won’t save you money, I still regret not contributing to a Roth IRA when I was in school and during my first year of work. But I can’t be blamed too badly for my lack of contribution because it only became a savings option to the public in 1998, when I was a junior at William & Mary.

The last thing I was thinking about junior year was saving for retirement. All I wanted was to get a job and prove that going to college was worth it. By the time I understood the merits of contributing to a Roth IRA, my income had surpassed the income limit to be able to contribute.

Therefore, I’m making up for my mistake by contributing to a custodial Roth IRA for my kids. Thanks to the standard deduction and their low wage, they’ll essentially get to earn tax-free money to be able to contribute to a Roth IRA. I recommend doing the same for your low-income earning kids.

Contribute to a Roth IRA when you can. Even if you just have $20,000 in a Roth IRA, it will grow to over $200,000 in 30 years if it compounds at 8%. If you can invest in a moonshot that becomes the next Facebook, then it’s obviously worth investing your Roth IRA money if you can.

Still Not Doing A Roth IRA Conversion Today

But in terms of doing a Roth IRA conversion now, I still can’t succumb. It feels like one last trap the government is setting to get Americans to fork over even more money. Further, my tax bracket is too high.

All of us have the ability to adjust our income, and therefore, our tax rates in retirement by:

  • Moving to a more tax-efficient state
  • Rebalancing our portfolios to non-dividend-paying investments
  • Donating more of our wealth to charity while living
  • Gifting more of our wealth to our children and other individuals
  • Investing in new non-income producing investments
  • Starting a business
  • Withdrawing at different rates

As soon as you do a Roth IRA conversion, it’s like surrendering to the government. Sure, you’ll get the tax-free benefits upon withdrawal. But even that is not a certainty. The government could always pass new legislation.

The irony about eliminating the Roth IRA conversion is that Congress might actually save thousands of Americans lots of tax dollars. The headlines about how one man was able to earn a 100,000X return on his Roth IRA is unlikely going to happen for most Americans.

If you must do a Roth IRA conversion, make sure you run various scenarios. The “worst” case scenario is if you end up making more in retirement than while working. If so feel extremely blessed! Paying more in taxes because you failed to do a conversion isn’t that big of a deal.

Psychologically, you can think about paying more taxes than you could have as a contribution to society. This goes for both a traditional and Roth IRA. Just don’t think about all the waste and corruption.

The Best Time To Do A Roth IRA Conversion

In retrospect, the best time to do a Roth IRA conversion for me was in 2013. 2013 was my lowest income year because it was the first full year I didn’t have a job. I stopped receiving a steady paycheck by June 2012.

Unfortunately or fortunately, even unemployed, I was still in the 28% marginal federal income tax bracket ($87K-183K for individuals) at the time because tax rates were higher then. Further, I was earning passive investment income, some online income, and had deferred investment income as part of my severance package coming in for the next four years.

Paying six-figures in taxes to do a Roth IRA conversion wasn’t enticing when my income was still way down. Therefore, I decided to just roll over my 401k into a traditional IRA. Psychologically, you will probably also feel like holding onto as much wealth as possible if you lose your job.

Therefore, the best time to do a Roth IRA conversion is when you are unemployed with little-to-no other income sources and there’s a bear market. At a 0%, 10%, or even 12% marginal income tax bracket, you should probably find the time to convert. There may not have a better opportunity in the future.

Further, Roth IRAs aren’t subject to Required Minimum Distributions at age 72, unlike traditional IRAs and 401(k)s. This comes in handy if you want to pass on your Roth IRA to someone else.

Making The Right Choice In Terms Of Probabilities

Here are my estimated probabilities for a positive outcome if you do a Roth IRA conversion at your current marginal federal income tax bracket. A positive outcome is defined as saving money on taxes.

  • 10% tax bracket: 95% chance contributing or converting to a Roth IRA is the right choice
  • 12% tax bracket: 90% chance contributing or converting to a Roth IRA is the right choice
  • 22% tax bracket: 70% chance contributing or converting to a Roth IRA is the right choice
  • 24% tax bracket: 60% chance contributing or converting to a Roth IRA is the right choice
  • 32% tax bracket: 40% chance contributing or converting to a Roth IRA is the right choice
  • 35% tax bracket: 30% chance contributing or converting to a Roth IRA is the right choice
  • 37% tax bracket: 20% chance contributing or converting to a Roth IRA is the right choice
  • 39.6% tax bracket: 10% chance contributing or converting to a Roth IRA is the right choice

If you make less than $125,000 as an individual or less than $198,000 as a married couple, you can contribute the maximum $6,000 to a Roth IRA. Paying a 24% marginal federal income tax rate is reasonable. You’ll likely come out ahead with a more diversified retirement income source.

But for those of you in the 32%, 35%, or 37% tax bracket, a Roth IRA conversion is likely going to end up costing you more tax dollars. The break-even tax rate is somewhere around 26% – 28% where converting or not won’t make a big difference.

Diversifying retirement income sources is great. However, always run different scenarios in this uncertain world. There’s a good chance what you think will happen will never happen.

Roth IRA Conversion Recap

  • Forecasting your retirement tax rate is the key variable
  • Tax rates are unlikely to go up for the middle class (up to ~$300K income)
  • You will likely make less in retirement than while working
  • Contribute to a Roth IRA when you can
  • For your highly speculative investments, make them in a Roth IRA if possible
  • You have more ways to lower your taxable income in retirement than you think
  • If you find yourself unemployed or underemployed, consider a Roth IRA conversion, even thought it will feel painful
  • Even if you end up paying more in taxes in retirement, feel grateful you did so well
  • So long as you are maxing out a a tax-advantaged retirement account that is the most important thing

Related posts:

How Much You Should Have Saved In Your 401k By Age

Recommended 529 Plan Amounts By Age: A Roth IRA Alternative

Use A 529 Plan For Generational Wealth Transfer Purposes

Readers, are you looking to do a Roth IRA conversion before Congress changes the laws? If so, what are your reasons for doing so? I’d love to hear more arguments for why a Roth IRA conversion isn’t a waste of time and money.

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A Roth IRA Conversion Is Probably A Waste Of Time And Money For Most is written by Financial Samurai for

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