How Roth Conversions Can Lower Taxes

Tim talks about how to reduce your lifetime tax liability by using Roth IRA conversions. By converting pre-tax money from a traditional IRA to after-tax money in a Roth IRA, individuals can avoid paying higher taxes in the future and potentially save a lot of money over time.

You can find the Part 2 video by scrolling down in this post.

We’ve talked about the problem that having most of your money in tax-deferred accounts like 401(k)s and IRAs can create a tax bomb when it comes time to withdraw Required Minimum Distributions (RMDs), or anytime you need to make a large withdrawal from your tax deferred accounts.

In a previous post, I discussed the rules and benefits associated with Roth IRAs.

Now I want to talk about what you can do to “diffuse” a tax bomb and reduce your lifetime tax liability by using Roth IRA conversions. 

Roth IRA Conversions

A Roth IRA conversion takes pretax money from a traditional IRA and converts that money to after-tax money in a Roth IRA to enjoy the benefits of a Roth IRA.

Why would you do this?

• Withdrawals of Roth IRA earnings are tax free and penalty free beginning at age 59½, as long as the account has been open at least 5 years.
• There are no Required Minimum Distributions (RMDs) from Roth IRAs for the owner, so the account can grow until you need it.

The amount of money converted is considered income in the year of the conversion, and you will need to pay income taxes on that income based on your current ordinary income tax rates.

Then you will never pay income taxes on that money again (once the account is qualified) because Roth IRAs give you tax-free earnings and withdrawals in retirement.

By paying taxes now, you’re leveling out your tax burden and reducing your lifetime tax liabilities. You are basically paying taxes now on your pre-tax retirement accounts to avoid paying taxes later.

At the moment, with income tax rates at historically low levels, filling up lower income tax brackets with Roth IRA conversions can be a great tax planning strategy and one we are recommending and using frequently at my firm.

I know what you’re thinking. Why would you want to pay taxes before it’s absolutely necessary?

To Defer or Not to Defer

Well, let's go through an example and see if it does or doesn't sense for you.

So, we've got $100,000 in an IRA. If we leave it there, that tax bill is just going to defer down the line until we either get to RMD age or we start to pull it out on our own. Let’s say our tax rate is 25% to make my math simple.

If we choose to take that money out of the IRA and convert it to a Roth, we have to pay the tax bill on the way over to the Roth. So that $100,000 minus the tax bill would mean we would end up with $75,000 in the Roth IRA.

So, again, the question is, should we do that? or can we do that??

Well, we can convert whatever we want. A conversion is not the same as a contribution, which does have income limits. But, for a conversion, there are no income limits and no age limits. Anybody can do Roth conversions on any amount at any time from their traditional IRA. But that's not the question, the question is, should we?

Let’s look at the example...

So, we're going to jump forward 10 years and see if this was a good idea or a bad idea.

In both situations, we will assume your accounts have doubled in value in 10 years. We would all take that, right? 

• So, if we didn’t do the Roth conversion, the $100,000 in your IRA grows to $200,000. 
• If we did do the Roth conversion, the $75,000 in your Roth IRA would have grown to $150,000. 

So, 10 years later the difference in account values is $50,000. But remember, it's about how much of your money you get to keep after you pay off the IRS.

So, when it comes time to spend the money from the IRA, we have a tax bill to pay, right? We’ll say the tax rate stays exactly the same at 25% today. After we've paid the tax bill on the $200,000 from the IRA, we're going to be left with $150,000.

That means with either option, we end up with $150,000 after taxes. So, it’s a wash. 

Let’s go back to the original question: do we defer our tax bill, or do we not defer our tax bill? Well, if your tax rates do not change, then it's a wash. 

But here’s how we need to think about this. If most of your money is sitting in IRAs and 401(k)s, or any type of pre-tax account, you’re making the bet that you think tax rates are going down... because you've chosen not to pay the bill today. 

You're deferring it to a later date, hoping it's a lesser rate or it stays the same. And if you’re still working, this is probably fine. But if you’re retired or close to it, you’d better start paying attention. 

So, let me ask you, do you think it’s likely our tax rates, which are at historically low rates and have been coming down for decades, are going up or down in the future?

Well, my industry is literally calling what we have now, a tax sale, and almost everyone I’ve asked has said they think it’s more likely our tax rates will go up from here rather than down. And I’d agree with that.

And, if you think rates are going up, and 80% of your money is in an IRA, then your thoughts and beliefs are not aligned with your money. You’re just going to be paying Uncle Sam more in taxes. 

Now, let’s look at a hypothetical situation to see how Roth conversions can help save in taxes. 

The above video uses 2023 tax information. Amounts below have been updated to 2025 income tax brackets.

Scenario 1: Without Roth Conversions

First, let’s say you’re retired, you no longer have earned income, and you have $600,000 in a traditional IRA.

Then, let’s say you need access to all of that money right now because you have to pay a load of medical bills, pay for long-term care, buy a second home, or get a bunch of facelifts and Botox. You’re probably getting the picture that it doesn’t matter what you need the money for -  you just need it.

If you have no other income and need to take all $600,000 out of your IRA in a single year, you will pay around $144,000 in taxes (rounded figures). This assumes you are married filing jointly and this puts you in the 35% tax bracket for 2025.

For those of you that like to see how that's calculated, here you go:

Scenario 2: With Roth Conversions

Now, imagine you worked with me, and we converted $100,000 per year from your IRA to a Roth IRA over the last 6 years. You would have paid under $8,000 per year for a total of around $48,000.

So, in this scenario, by using Roth conversions, you saved approximately $91,000 in taxes, and your money is now in a tax-advantaged Roth IRA.

I hope this gets your attention now. How does this work, you ask?

Well, let’s say you are a married couple that is recently retired and no longer has earned income. Since you no longer have ordinary income, you can convert up to around $100,000 from your IRA to a Roth IRA in the 10% and 12% tax brackets after the $30,000 standard deduction in 2025, and another $1,600 per person if you are over 65.

By “filling up” the lower marginal tax brackets, you would pay only 10% and 12% tax on the Roth conversion and have all the tax-free advantages of the Roth IRA moving forward.

And again, for those of you that like to see how that's calculated: 

When Should you Consider Roth Conversions?

1. If you have a temporary dip in income for whatever reason and you think your tax rates will be higher in the future - This could happen throughout your life; it doesn’t necessarily have to be at retirement age.
2. If you’re in or getting close to retirement and ready to start planning for it
3. Legacy planning - Unlike traditional IRAs, Roth IRAs have no required minimum distributions (RMDs). The money just grows until you need it or your retirement is over.

Going Further

This is a simple scenario in dollars that shows you how Roth conversions over time can really help lessen your lifetime tax liabilities. 

For a more detailed, real world example, see this post and YouTube video: How Much Can I Save with Roth Conversions?  That's where I walk through two software programs we use when we're determining whether or not it would be advantageous to do Roth conversions, and maybe give a ballpark estimate of how much they might save over their lifetime. 

*As always, be sure to consult your tax consultant or financial planner before implementing any changes. But the flexibility and benefits of a Roth IRA account should not be overlooked with almost any plan. 

Sources: 
https://www.nerdwallet.com/article/taxes/federal-income-tax-brackets

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