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Why Converting Everything to Roth is a MISTAKE · Retirement Answers

• 0:00
  Jacob: What if I told you that converting everything to a Roth IRA is a bad idea? Your first thought might be, what are you talking about? I thought Roth conversions were good and I thought I should be doing as much as I possibly can. And you're definitely right, at least in part. Getting money to a Roth IRA helps reduce future tax burdens.
• 0:16
  But there are a few things here that you've got to think about and consider that you might be overlooking at least at this point. And so I wanted to talk today about why converting everything to a Roth could be a mistake because of something that people overlook when thinking about their future tax situation. Hey there, thanks for tuning into this week's episode of Retirement Answers. My name is Jacob Duke. I'm your host as always.
• 0:36
  I also own a retirement planning firm where we help people just like you plan smarter so you can retire better. So let's dig into this conversation around Roth conversions and maybe why you don't need to convert as much as you otherwise think. So when we think about a Roth conversion, what's really the benefit of it? Well, the idea is if you can convert or move money from a traditional IRA to a Roth IRA at a lower tax rate today, compared to whatever your tax rate would be in the future, whenever you draw money from that traditional IRA, it might be a good idea. So for example, let's say you are 62, you just retired and you have no other income at this point, you haven't turned on Social Security just yet, and you have the opportunity to create income, at pretty much 0%, 10% or 12% tax bracket, depending on how much income you generate.
• 1:23
  So those tax brackets are relatively low, at least historically, and so what you'd want to do there is, you know, you obviously have to have income to live on, so maybe you have to pull some out of your traditional IRA to live on, but you might want to think about, hey, what if I converted at least a portion or some of the money into my traditional IRA over to a Roth IRA at this 10 or this 12% tax bracket? Now, you have to consider here is would that tax rate you're paying today be higher or lower or the same as what you could be paying in the future? So once you have maybe Social Security or a pension or something else turned on in the future, your income tax brackets could be at a minimum 10 or 12% in the future, meaning any distributions out of your traditional IRA could be at 22%, let's say in the future, whenever you have to take money out. So the issue here is that your RMDs, depending on what your other income sources or fixed income sources might be in the future, your required minimum distributions could push you into higher marginal tax brackets, meaning that the dollars you take from your IRAs at that point would be taxed at a higher rate compared to what they could be today.
• 2:23
  So the idea by doing this conversion, at least at this point with a 10 or 12% tax rate, could be to reduce how much income tax you would pay at 22% in the future, And that's a big difference. That's a 10 to 12% difference in tax rate paid. Obviously, this assumes that the tax rates that are current law are going to be sustained throughout the future. Obviously, we have to assume a few things for this thought logic to work out in the way we want it to. But in general, you can see that paying taxes today could end up saving you taxes over your lifetime compared to just delaying or deferring more taxation into the future because you could have higher tax rates later on.
• 2:59
  So in general, that's the basic idea of why Roth conversions are helpful or what you could even benefit from them. So pay tax today at a lower rate than you otherwise would in the future, it might be smart to do them. Now, here's the problem, you know, whenever I talk about this or anyone else talks about Roth conversions, you know, many people come to me and they say, Jacob, I want to convert to Roth. How much should I convert? When should I do that?
• 3:20
  Should I convert everything? And the thing there is like, you know, number one, I can appreciate that you're thinking strategically and trying to find ways that you wanna save more of your hard earned money and keep more of that in your pocket and help it go further. But the thing here is this, we have to evaluate how much you actually need to convert. Because when you ask, hey, should I convert everything? Often my answer is going to be no, and here's why.
• 3:44
  When we think about how the the tax code is structured, it stacks on top of each other based on different sources of income. We're going to walk through an example in just a moment, but with a standard deduction, which in 2025 for a single filer is $15,000 and for a married filing jointly couple, it's going to be $30,000 and if you're above a certain age, if you're above 65, or if you're blind, you can have additional add ons on top of that basic standard deduction. And just a little tidbit here, there is talk about at least at this point within the current bill that's being proposed through the house and then going to the Senate, that there is an additional add on, you know, deduction for people of a certain age as well to kind of help offset against Social Security taxation. We'll see if that makes it through or not, but right now there is talk about it. So these standard deductions, what this effectively does is this creates a 0% tax bracket.
• 4:34
  This is what I call the 0% bracket. So let's say that you're married filing jointly, okay, you have a $30,000 I guess cushion to take money from somewhere and pay no tax on it. So let's say you don't have a pension, let's say that you don't have Social Security, and let's say you just have a traditional IRA. Well, you can take $30,000 from that traditional IRA, assuming you're married filing jointly and pay no income taxes on that money. So that's the 0% tax bracket.
• 4:59
  Now, as soon as you start to add income on top of that, maybe from Social Security or a pension, or maybe you take more than $30,000 out of a traditional IRA or any sort of tax deferred account, you would obviously have your standard deduction, which gets subtracted out of the total and then whatever's left, that's what moves on to the 10% bracket and then you know, obviously goes on to 12% bracket at that point as well. So the thing here to know is that you do have a 0% tax rate, at least on the first amount of money depending on your tax filing status. So if you think about this in this way, in some sense, you want to always fill up that 0% tax bracket or use that standard deduction. So if you have everything in Roth, and your only source of income is social security, and you're only pulling money out of a Roth IRA, guess what? You're not using all of that standard deduction.
• 5:45
  You're using a part of it based on your Social Security taxation, and we'll walk through an example of how Social Security is taxed here in just a moment, because it's not taxed the same as everything else, but you would still be leaving some free money on the table. So in some sense, you want to have taxable money from a traditional IRA that you can pull up to a certain point, you'd have to do some math to figure out exactly how much you can pull at a 0% rate using that standard deduction, but to have money in that traditional IRA means you deducted it whenever you put the money into your four zero one ks or a traditional IRA while you were working, so you deducted it there, didn't pay tax at that point, let's call it twenty years ago. Well, whenever you get to this point and you have this opportunity retirement to maybe pull money out of a traditional IRA completely tax free because you're using it against that standard deduction, you didn't pay tax on the front end and you're not going to pay tax on the back end, and that is pretty awesome.
• 6:33
  So let's walk maybe through an example together just to see how this might play out, you know, in practice. Let's assume that you're a single tax filer, and so you are currently taking social security, let's say you're 67 or after, and you decided to wait. So right now you're getting about $3,000 a month in Social Security benefits, you have no pension. Let's assume that you also don't have any sort of other income, right? Maybe you have some dividends or interest here and there, but we're not really going to factor that in at least at this point.
• 7:01
  Let's assume your Social Security is your only form of taxable income. And then right now, today, at least you haven't taken any money out of your IRA. Let's figure out how much money you can actually take from a traditional IRA as a single tax filer and pay no income tax on that distribution. So again, 3,000 a month of Social Security that comes out to about $36,000 per year. But what we have to do here is kind of back into how much money we can actually take out of your traditional IRA completely tax free by understanding how Social Security taxation works.
• 7:30
  And I've done different episodes on this. In fact, I've done it also in video format on YouTube, so you go check that out. I'll have a link down in the description below. But what you've got to know about social security taxation is that it's not taxed entirely the same as normal income. In fact, at most 85% of your social security benefits are even subject to taxation, and we're going to walk through calculating how much actually is subject to taxation.
• 7:52
  But if your only form of income is Social Security, then you're not going to pay any tax on any of that. Here's an example. Let's say that you again, in this situation have $36,000 a year of social security. Well, in order to figure out how much of that is actually subject to taxation or is taxable, we've got to find something called the provisional income and then run that through provisional income brackets. So the way we do this is we take half of your Social Security benefit amount, and then we add in other incomes such as IRA distributions or pensions or earned income.
• 8:21
  And we also have to add in non taxable municipal bond interest to this. But let's say again, we don't have any of those other income sources at least at this point. So $36,000 we take half of that amount, so that's $18,000 we add zero to that because we don't have any other income at this point. We take that $18,000 and we run that through the provisional income tax brackets. And again, if you've not seen the PDF that I'm freely giving away, then you can shoot me an email just hey, Jacob, I want to see the important numbers PDF, can you send me a copy of that?
• 8:49
  I'll happily send that over to you, it's completely free, where you can use exactly what I'm talking about here, you can see it visually and see these provisional income brackets in a clear concise manner. But as a single tax filer, the first provisional income tax bracket is 0 to $25,000 and then it goes from 25,000 to 34 and then 34 and above. So those are the three different brackets. And what those are telling us is, is at each of those levels, it tells us how much of the income, the Social Security income that actually falls into those brackets is subject to taxation. So the first one is 0 to 25,000 for a single filer.
• 9:24
  And so any any dollars that fall into that bracket, guess what? 0% of that amount is subject to taxation. Okay, so 0% from the first 0 to 25,000, anything from 25,000 to 34,000, 50% of the amount that falls into that range. So think about it this way, it's a $9,000, gap there. Means $4,500 if it's all the way filled up, dollars 4,500 is going to be how much is actually subject to taxation of your Social Security benefit.
• 9:54
  And then anything from 34,000 and above, anything that falls in that range there, that's telling us that 85% of that amount is subject to taxation in regards to your Social Security. So here's the first example, let's walk through it. So 18,000, remember that number we just talked about a second ago, that's half of your current Social Security amount. So technically, 18,000 does not eclipse that $25,000 bracket, the first one there of the provisional income brackets, meaning that 0% of the 18,000 is subject to taxation, which means none of your social Social security benefits, none of your 36,000 is subject to taxation. So that's an example of how your social security benefits are not subject to taxation.
• 10:33
  Now we can take this even further just as a quick example and say that 4,000 a month is your total benefits as a single filer, which means 48,000 is how much you get annually. So if we take half of that amount to find a provisional income, that means 24,000 is the number we come out to. And again, we have no other income at least at this point. And so 24,000 again is still less than 25. So all that would fall into that first provisional income tax bracket, which means that 0% of that Social Security amount of 48,000 is subject to taxation.
• 11:02
  So that's why and how it actually works in terms of the math behind the scenes to see how much of your Social Security is taxed. But now let's add in some other income here to see how much we can actually pull from your IRA completely tax free using standard deduction and using this Social Security taxation method to your advantage. So back to the original scenario where we had $3,000 a month, which is $36,000 a year of Social Security income. I've done the math a little bit beforehand just to make this a little bit shorter and easier for you instead of running through it multiple times, but it took me about four tries of doing the math to figure out exactly how much we could pull from the IRA completely tax free in this scenario. So 36,000 social security, and then we're gonna be able to take $12,000 out of the IRA completely tax free.
• 11:46
  And here's how the math works. So remember, we've got to calculate the provisional income first. So 36,000, we take half of that, which is going to be 18,000. We then add any other income in this case, now we have additional income that 12,000 from the IRA, we add that to it, okay, and so 18 plus 12 equals 30. So $30,000 is our provisional income, and so what you can see here is this is gonna be a little bit different than the first two examples I gave you, because now we have money that eclipses that $25,000 threshold of the first provisional income tax bracket.
• 12:18
  So, 30,000, the first 25,000 of that, none of that amount is subject to taxation in terms of how we calculate this, And then we have $5,000 left over, and that falls in that range of 24 to 34,000. That tells us that 50% of the amount in that range is subject to taxation. So we've got $5,000 in that middle range there, that means $2,500 of our social security is subject to taxation, even though we have a total social security amount every year of 36,000, only 2,500 is actually subject to taxation, and that's how we calculate how much of your actual benefits are taxable. So, dollars 2,500 of your Social Security is subject to taxation. What we do at this point is we take that number, and then we add in the additional IRA distribution, which is $12,000 and what that does is that tells us that $14,500 is actually our AGI, our taxable amount of income that we have to pay taxes on.
• 13:18
  So 14,500, that is less than the standard deduction of $15,000 right? So that's $500 less than the standard deduction, which means that none of our Social Security is taxable in this scenario. And then none of that $12,000 of the IRA distribution is taxable in this scenario either. So that's pretty cool, right? Basically, none of your Social Security is taxable in this scenario and then also, none of your tax deferred IRA money is taxable in this scenario.
• 13:43
  So again, you got to take the tax deduction on the front end to put the money into that tax deferred account, and now you get to take the money out completely tax free. And so, here's kind of to wrap this all of them and bring this back to whether or not you should convert everything to a Roth. Well, if you think about it this way, at age 73, if we use the uniform life expectancy tables to calculate your RMD, what this is telling us is that you could actually have a $318,000 traditional IRA account balance in the previous year end, and your RMD would be $12,000 And if your Social Security is this amount in this scenario, then you would actually be able to take your RMD completely tax free. So what that tells us is this, is that you shouldn't convert, at least under these assumptions and using this Social Security income amount, obviously, you have to use this and tailor it to yours and use kind of the concepts here and back into your numbers. But we can see by doing it this way, that we should actually not convert all of our traditional money down below this number because our RMD would actually be low enough if we can make it equal $12,000 by having a certain amount of money in our tax deferred accounts.
• 14:49
  We wouldn't want to convert past that amount because then we'd be not using up the full $12,000 of tax free distribution from the IRA. So our RMD in this scenario could be completely tax free, as well as our social security income being tax free too. So here's the overall takeaway, is just because you've heard Roth conversions are good, and they are, they can be helpful, but they're not always helpful for everyone, or they're not helpful in extremes, meaning maybe you don't need to convert everything because then you wouldn't be able to use $12,000 in this scenario out of your traditional IRA completely tax free because you wouldn't have any money to take out of your traditional IRA. Yes, it feels good to have all Roth because then you're not paying tax on anything, but I'm showing you that you don't have to pay tax on certain amounts if you can find a way to strategically convert at least down to a certain amount so that your RMD projections are not so high that you would then be able to use this 0% tax bracket to your advantage. So hopefully this gives you some things to think about and maybe some ways to kind of press pause on the Roth conversion thing and really analyze it for for what it should be analyzed as it's not a blanket statement that everyone should be doing Roth conversions because you might not need to be.
• 15:58
  And then another big factor in all this too is, is what is your age? Like what are your goals? If you're 75 or 80 trying to do Roth conversions, well, it might be helpful not for you, but for someone else down the road, maybe an heir or someone who's going to be receiving this money completely tax free, because the break even point or the amount of time it takes to recoup some of the taxes that you've paid could be past your life expectancy. So you've got to think about, you know, when are Roth conversions the best time to do them and how much should I be converting? And how does this impact my plan long term.
• 16:27
  I know that this scenario I just gave you doesn't, you know, fit everyone, but the point of this episode is to kind of tell you that there are some negatives that can happen if you do too much in conversions, especially if you convert everything, you'd be giving up opportunity to use that 0% bracket, or even use that 10 or that 12% bracket that could be much less than your tax brackets today while you're working. So if you've got a question on this, or if this doesn't make sense, feel free to shoot me an email, it should be listed down in the in the description below. Also, if you want to have your question featured here on a future Friday q and a episode, there should be a link down below as well to ask that question. And again, if you want a copy of that important numbers PDF to help make some sense of all this and really see the numbers that I've been talking about presenting here today, shoot me an email saying that you'd like a copy of that. I'll happily send that over to you.
• 17:11
  Other than that, I hope you have a wonderful rest of your week and we will talk to you again very soon. Hey, it's Jacob again, and I wanted to remind you that nothing discussed in today's episode is meant to be financial, legal, or tax advice. Retirement Answers is for educational purposes only. Thanks for tuning in to this week's episode. I look forward to talking with you again next week.