I’ve spent the better part of my career helping people avoid paying unnecessary taxes. We’ve deferred income, maximized deductions, harvested tax losses, and generally done everything legally possible to keep the IRS from getting its hands on more money than necessary.
And now I’m going to suggest something that seems to contradict pretty much all of that: You should consider voluntarily paying more taxes.
Not because you have to. Not because the IRS sent you a letter. Not because you forgot to report the $37 you won playing the slots at the casino.
But because it might actually be a good idea.
I realize this sounds like the kind of financial advice you’d get from someone who recently suffered a fairly significant head injury, but hear me out.
We’ve Been Avoiding Taxes for Decades. What’s Changed?
For most of our working lives, we’ve been told to put money into tax-deferred retirement accounts. Traditional IRAs, 401(k)s, 403(b)s, you name it.
And for good reason. You contribute money, get a tax deduction, and allow those investments to grow without paying taxes along the way.
It’s a pretty good arrangement.
The only minor issue is that the IRS hasn’t actually forgotten about that money. They’ve just agreed to wait.
Think of your traditional IRA as a rental property you’ve spent the last 40 years maintaining and improving. You’ve paid for the renovations, replaced the roof, and dealt with the occasional sewage backup. Meanwhile, you’ve got a silent business partner who hasn’t lifted a finger but is still entitled to a percentage of the profits.
That’s Uncle Sam.
And the best part is that you don’t even know exactly what percentage he’s entitled to until you start taking money out.
What a deal.
So What Exactly Is a Roth Conversion?
The concept is actually pretty simple.
You take money from a traditional IRA, move it into a Roth IRA, and pay income taxes on the amount converted.
That’s it. That’s the whole strategy.
You voluntarily send money to an organization whose customer service department is best known for hold music and threatening correspondence.
In exchange, the money in your Roth IRA can grow tax-free, and assuming you meet the applicable requirements, you can withdraw it tax-free as well.
You’re essentially paying the taxes today in hopes of avoiding a larger tax bill later.
And while that might sound ridiculous, for some retirees it can be an incredibly effective strategy.
For others, it’s a spectacular way to waste money.
The difference is in the planning.
Required Minimum Distributions: Because (Obviously) You Can’t Just Keep Your Own Money
Let’s say you’ve spent 40 years saving for retirement. You’ve invested responsibly, lived within your means, and accumulated a nice seven-figure traditional IRA.
Congratulations. You’ve done exactly what you were supposed to do. Now the government would like you to start taking that money out. Welcome to Required Minimum Distributions, or RMDs.
Beginning at age 73 or 75, depending on your birth year, the IRS requires you to withdraw a portion of your tax-deferred retirement accounts each year.
Don’t need the money? Doesn’t matter.
Would rather leave it invested? Too bad.
Want to pass it along to your children? That’s nice, but Uncle Sam would prefer to get his share first.
And here’s where things can get particularly frustrating. These forced distributions may push you into a higher tax bracket, increase the amount of your Social Security benefits subject to taxation, and even result in higher Medicare premiums.
You heard that right, higher Medicare premiums.
Because apparently paying more in income taxes wasn’t enough punishment for having the audacity to save for retirement.
Roth IRAs, on the other hand, don’t have lifetime RMDs for the original owner. Which creates an interesting opportunity.
The Best Time to Pay Taxes Might Be When Nobody Is Making You
One of the most overlooked opportunities in retirement planning is the period between retirement and the beginning of Social Security and RMDs.
Think about it.
For decades, you’ve had a paycheck coming in. You’ve paid income taxes, contributed to retirement accounts, and hopefully saved a substantial amount of money.
Then you retire.
Suddenly, your taxable income might be considerably lower than it was just a year earlier. You may have several years before Social Security and RMDs begin adding income back into the equation.
In other words, you’ve got a window where your tax rate might be relatively low.
This is where Roth conversions can make a lot of sense.
Rather than waiting until RMDs start forcing money out of your retirement accounts, you can convert portions of those accounts over several years while potentially taking advantage of lower tax brackets.
Maybe you convert $30,000 this year. Maybe $50,000 next year. Maybe nothing the following year.
It depends entirely on your situation.
The idea is to pay taxes while they’re relatively inexpensive, rather than waiting until the government decides it’s time to start collecting.
Basically, we’re trying to give the IRS as little money as possible. Unfortunately, sometimes that means giving them more money first.
Makes perfect sense, doesn’t it?
Of Course, You Can Also Completely Screw This Up
Now, before you rush out and convert your entire $1.2 million IRA because some guy on YouTube told you Roth accounts are the greatest thing since sliced bread, there are a few things worth considering.
Let’s say you’re currently in the 12% federal income tax bracket.
You decide that Roth conversions sound like a terrific idea, so you convert $800,000 in a single year.
Brilliant.
You’ve now pushed yourself into substantially higher tax brackets, potentially increased your future Medicare premiums, and created an enormous tax bill that nobody was actually forcing you to pay.
But hey, at least you won’t have to worry about paying taxes on that money again.
You’ve already paid a fortune.
Maybe the IRS will name a conference room after you:
The Tyler Meyer Conference Room: Proudly Funded by One Completely Unnecessary Roth Conversion
The point is that Roth conversions aren’t automatically a good idea. And even when they are, the amount you convert matters just as much as the decision to convert in the first place.
You need to consider your current tax bracket, future retirement income, Social Security, Medicare premiums, RMDs, and what your tax situation is likely to look like 10 or 20 years from now.
Not exactly exciting stuff, but neither is unnecessarily donating an extra $50,000 to the federal government.
What If You Just Die and Leave the Problem to Your Kids?
That’s certainly an option. And frankly, one that doesn’t get nearly enough consideration.
Unfortunately, your children might not appreciate it quite as much.
Under current rules, non-spouse beneficiaries are required to empty inherited retirement accounts within 10 years.
If you leave your kids a substantial traditional IRA, those withdrawals often occur during their highest-earning years, when they’re already paying relatively high income tax rates.
So after spending your entire life trying to minimize taxes, you may have inadvertently arranged for your children to make some rather generous contributions to the federal government.
How thoughtful.
Inherited Roth IRAs are generally still subject to the applicable 10-year distribution rules, but qualified withdrawals are tax-free. For families planning to leave substantial retirement assets to the next generation, that distinction can be pretty significant.
Of course, if your kids are terrible with money, perhaps the IRS deserves a turn.
So Should You Be Doing Roth Conversions?
Maybe.
I know, that’s probably not the definitive answer you were hoping for.
But the truth is that Roth conversions aren’t inherently good or bad. They’re simply another tool available when planning for retirement.
The goal isn’t to pay the least amount of taxes this year. It’s to pay the least amount of taxes reasonably possible over your lifetime.
And those are two very different things.
Sometimes voluntarily paying $10,000 in taxes today could save you considerably more down the road. Other times, paying that $10,000 would be a complete waste of money.
At QED Wealth Solutions, we evaluate Roth conversions as part of an overall retirement income and tax-planning strategy. That means looking at current and future tax brackets, Social Security, RMDs, Medicare, estate planning, and a number of other factors before deciding whether a conversion makes sense.
Because the last thing I want to do is recommend that someone pay more taxes than necessary.
Even if that means recommending they pay more taxes today.
Yes, I realize how ridiculous that sounds.
But if voluntarily writing a check to the IRS today means keeping substantially more of your money over the next 20 or 30 years, I’m willing to entertain the idea.
I still wouldn’t expect a thank-you card from the IRS. Apparently, taking your money is thanks enough.
This post is for education and entertainment purposes only. Nothing should be construed as investment, tax, or legal advice.