Roth Contributions and Conversions: Why This Strategy Is Not Always the Best Choice for You

Written by Alex Seleznev, MBA, CFP®, CFA

The trend toward “Rothification” of your retirement contributions and Roth conversion has been popularized over the past number of years.

To be fair, there are some significant benefits of Roth contributions and conversions. Specifically, even though you do not receive any upfront tax deductions, or need to pay taxes in many cases when you convert into the Roth, the funds in these accounts grow tax-free. This eliminates, or at the very least reduces, the risk of the impact of higher taxes on your portfolio in the future.

But should everyone follow this trend and is this truly the best choice for each person? In this article, we explore some of the ideas that are frequently discussed as part of this conversation.

Are you in a high(er) tax bracket today?

On the federal level it would be anywhere between 24% to 37%. We should also consider local taxes for those who live in states that impose income taxes such as Maryland or California. In many cases, this “additional” tax will be anywhere between 5% to 7% or even higher.

Any time you choose to contribute into your Roth IRA or 401(k) instead of the Traditional option, you are essentially not saving anywhere between 30 to 40 cents on each dollar of your contribution. This can be quite significant, specifically when you continue with this approach for years or even decades!

One way to describe the impact of Traditional or deductible IRA or 401(k) contributions is an almost immediate “rate of return” that is equivalent to your marginal tax bracket. With Roth conversions, your immediate “loss” is also equivalent to your tax rate because you have to pay taxes which essentially reduces the value of your investment.

One of the logical alternatives is to invest the tax savings on your Traditional 401k or IRA contributions. This is a conceptual point because most people do not think of their funds and accounts as fungible. However, this approach is quite simple for those who want to implement it.

As an example, assume you contributed $22,500 into your Traditional 401(k) account and your marginal federal and state income tax brackets are 35% and 8%, respectively. This means that your immediate tax savings on the contribution are equal to $9,675 ($22,500 multiplied by 43%). This is almost $10,000 in savings for those in these higher tax brackets!

Your tax savings can be invested for growth, specifically in equities or funds that make minimum dividend payments to reduce your annual tax liability. You can create a “mini-Roth” account for yourself!

There is certainly a possibility that you will have to pay capital gain taxes in the future. The capital gains tax rate is usually lower than for ordinary income and, in some cases, you are able to offset your capital gains with losses on your other positions. Years 2020 and 2022 presented many opportunities for capital loss harvesting.

What about your tax rate in retirement?

Many people believe they will be in a higher tax bracket when they retire. At least on the surface, this assumption is logical because they have been accumulating funds over many decades. In addition to the Required Minimum Distributions (RMD) and Social Security income, some retirees will also have pension or other annuity-like income in retirement.

After helping hundreds of clients successfully transition into retirement, I can tell you there is a low probability of such a scenario for most individuals and families. In practice, in only one out of ten cases there is a strong possibility of a higher tax burden in retirement.

Most people and specifically those in professional occupations experience peak earnings in the last decade of their employment which frequently puts them in one of the higher tax brackets. Furthermore, it is advisable to discuss your actual distribution plan at least three to five years prior to your retirement date to ensure you optimize it for maximum tax efficiency.

It is relatively rare for most retirees to maintain or need to maintain the same level of income in retirement. This is one of the reasons why as a rule of thumb we usually project that an average person will need anywhere between 60% to 70% of their regular income in retirement. At the very least, they no longer save for retirement or pay Social Security and Medicare taxes at this stage in the game.

Also, not every income source is taxed at the same level. As an example, Social Security income is taxed up to 85% on the federal level and not taxed by most states. Many investors maintain at least some of their savings in regular brokerage accounts which also reduces their overall tax liability when they begin to draw from their accounts. As mentioned earlier, dividend and capital gain tax rates are usually lower than ordinary income tax rates.

Do you expect higher tax rates in the future?

Without going into much detail about the reasons, there is a possibility that tax rates will be higher in the future. However, even those who are convinced of this possibility need to understand that this point is speculative.

At least as of today, we do not know if or when tax rates will be increased. We do not know what income levels will be impacted the most. Also, there is a remote possibility that even Roth accounts (!) will be subject to taxation at least for those with incomes above a certain level.

It is difficult to make predictions, especially about the future. If you are in a higher tax bracket today, keep this in mind next time you consider Roth contributions or conversions.

As a brief disclaimer, in this article I mostly wanted to address the concepts of why the Roth contributions and conversions are not always the best choice for everyone. There are many calculators that can be used to evaluate the benefits of each approach and decide what works best for each individual.

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