Could a Roth Conversion Actually Cost Me More Money?

Could a Roth Conversion Actually Cost You More Money? Roth conversions are often presented as an obvious tax-saving strategy. Pay taxes now, move money into a Roth IRA, and potentially enjoy tax-free withdrawals in retirement. Sounds like a pretty good deal, right? But what if converting your money actually leaves you worse off financially? In this episode of She's Talkin' Money, financial planner Shari Rash breaks down the real cost of a Roth conversion and why the money you use to pay the tax bill matters just as much as the conversion itself. You'll learn what happens when you use money from your IRA to pay conversion taxes, why you could face an additional 10% early distribution tax if you're under 59½, and why paying the bill with cash isn't automatically the better answer. We'll talk about how Roth conversions affect your emergency savings, investments, bonuses, and monthly cash flow, plus how to decide how much to convert based on your income, tax bracket, and long-term goals. You'll also learn when waiting until retirement might make more sense, how Roth IRA withdrawal rules work, and why becoming work-optional before traditional retirement age can change the equation. Because the real question isn't just whether you can afford the taxes today. It's what you're giving up to pay them. Roth conversions can be a valuable financial planning strategy, but a smart tax decision isn't always a smart financial decision. Links Learn more about financial planning with GWA Wealth Connect with Shari Thank you for being part of the She's Talkin' Money community! I'm glad you're here. Wondering whether a Roth conversion makes sense for your financial situation? Learn about working with Shari at GWA Wealth. Follow Shari on Instagram: https://www.instagram.com/shestalkinmoney/ Sign up for the She's Talkin' Money newsletter Enjoying the show? Follow or subscribe on your favorite podcast app and share this episode with a friend. Leave a rating and review on Apple Podcasts: https://podcasts.apple.com/us/podcast/shes-talkin-money/id957163760 Shari Rash is a financial planner and Investment Adviser Representative of GWA Wealth, a Registered Investment Adviser. This podcast is for educational purposes only and is not personalized investment, tax, or legal advice. Nothing discussed should be considered a recommendation, and listening does not create an advisory relationship. Investing involves risk, including possible loss of principal. Please consult your own financial, tax, or legal professional before making decisions based on your individual circumstances. Learn more about your ad choices. Visit megaphone.fm/adchoices

• 0:01Speaker 00

  This episode is brought to you by Google Chrome. You think you know a browser, but Gemini and Chrome, that's new. It can help you with practically anything on the web, like restoring a vintage motorcycle from a 50-page restoration blog, or finally break down that long article you've had open for weeks. Gemini and Chrome is here for it. Ready to make anything online make sense? There's no place like Chrome. Check responses set up required. Compatibility and availability varies 18 plus.

• 0:26Speaker 01

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• 0:57Speaker 02

  This episode is brought to you by State Farm. Football has a play for just about everything. You can go deep, keep it on the ground, or draw up something nobody sees coming. And whether you want to run a flea flicker or the tush push, you need a plan to fit your unique situation. That's why State Farm takes the time to get to know you so they can help personalize coverage for your life and budget. Now that's a solid game plan. Like a good neighbor, State Farm is there.

• 1:25Speaker 03

  You've probably heard that converting a traditional IRA to a Roth IRA can save you money in taxes down the road. But what if your Roth conversion actually ends up costing you more money? If you're under 59 and a half, the way you pay taxes on the conversion could trigger an additional 10% penalty. And even if you avoid that penalty, there's another question I think is just as important. Where is the money to pay those taxes coming from? Your emergency fund? Your investments? The savings you're building so you can leave your job? Today, we're looking at the real cost of a Roth conversion, including a mistake that could cost you thousands of dollars

• 2:08Speaker 03

  and why a smart tax strategy isn't always a smart financial decision.

• 2:19Speaker 03

  Thank you so much for joining me today. This is She's Talkin Money. I'm Shari, 20 years in personal finance, founder of GWA Wealth, and deeply invested in helping women actually understand their money. I've seen firsthand how often women are given bad, generic, one-size-fits-all financial advice. And Roth conversions are a perfect example of why looking at just one account doesn't tell you whether you're making the right decision. So let me give you a little backstory of why I decided to talk about this today. I actually had a meeting last week with a podcast listener who wanted to talk to me about Roth conversions. And she is educated in her finances.

• 3:04Speaker 03

  She knows what's going on and she keeps hearing about Roth conversions and why they make sense. And we had such a great conversation that I was like, you know, let's share the wealth. Let's share the knowledge. If she's a listener and she has this question, I'm sure there's more of you out there that are also wondering the same thing. Which brings me to, if you have a question, send me an email, [email protected] or click the link in the show notes and schedule a chat with me. That's a great way to get your question answered right away. And then who knows, I may even bring it to the podcast. Okay, so let's have a quick refresher. What is a Roth conversion?

• 3:49Speaker 03

  A Roth conversion moves money from a traditional IRA or another eligible pre-tax retirement account into a Roth IRA. With a traditional IRA or pre-tax retirement accounts, the pre-tax money generally becomes taxable when you withdraw it. But with a Roth IRA, qualified withdrawals are tax-free. That is what's attractive about Roth IRAs is that you can start withdrawing this money in retirement and it's tax-free. A Roth conversion lets you pay taxes on previously untaxed money today in exchange for potentially tax-free growth and qualified withdrawals later. So for example, if you convert $50,000

• 4:32Speaker 03

  from an entirely pre-tax traditional IRA, that will generally add $50,000 to your taxable income for that year. So that's an important understanding that whatever you are converting adds right on top of your income as if you earned it. There isn't an annual dollar limit on how much you can convert. And the income limits that apply directly to Roth IRA contributions do not prohibit conversions. So you do not have to worry that I make quote unquote, "too much money" if you want to convert. But here's what I want you to understand. The amount you take out of your traditional IRA and the amount that ultimately reaches your Roth IRA aren't necessarily the same.

• 5:15Speaker 03

  So that brings us to the first potentially expensive mistake. Mistake number one, paying taxes out of your IRA. So a Roth conversion itself isn't generally subject to the 10% early withdrawal penalty. So if you were to withdraw from your pre-tax retirement accounts prior to 59 and a half and not have one of the qualifying reasons, not only will you pay taxes, but you will pay a 10%. But using part of your traditional IRA distribution to pay taxes can trigger that penalty if you're under age 59 and a half and no exception applies. So, and this is a big one that I don't think many people realize

• 5:58Speaker 03

  because they go, well, I'm going to convert to my Roth, from my IRA to my Roth, and I'll just use the IRA to pay the taxes. So I'll just end up converting less. Like if I want to convert $50,000, I'll pay the taxes out of the $50,000. So I'm really converting $35,000. Let's work through this example. So let's assume we have a 45-year-old woman who wants to convert $50,000 from an entirely pre-tax traditional IRA or pre-tax employer account. And so she expects to owe $15,000 in additional taxes. She has two options. Convert the full amount and pay the taxes with outside funds or have $15,000 withheld from the IRA distribution.

• 6:42Speaker 03

  So in both examples, the distribution amount is $50,000. When you pay the taxes with outside funds, the $50,000 is actually reaching the Roth. The $50,000 is actually going to the Roth. But when you pay the taxes with that $50,000, $35,000 is going to your Roth. Now we have a potential 10% penalty, not on the $50,000 that we converted and we're using outside money to pay the taxes, but on the $15,000 that's being withheld for taxes. There's a, there's where the Roth conversion is actually costing you more money than you expected

• 7:24Speaker 03

  because you are paying $1,500 in a potential 10% penalty. When we are paying for our Roth conversion with outside funds, then yes, our savings account, maybe an after-tax brokerage account, is $15,000 less now because we're using $15,000 to pay that tax bill. So both scenarios generally create $50,000 of taxable income. The $15,000 withholding is a payment towards the tax liability, but that may not necessarily be the final amount owed. It could be more, it could be less, depending on what shakes out when you're filing your taxes.

• 8:06Speaker 03

  So the $35,000 that was successfully converted into the Roth IRA generally avoids the 10% early distribution tax. But the $15,000 withheld for taxes is treated as a distribution rather than a conversion. And because our 45-year-old example is under 59 and a half, that $15,000 may be subject to that additional 10% tax unless the exception applies. So that means she could owe an additional $1,500 simply because of how she chose to pay the taxes. But here's the key takeaway.

• 8:47Speaker 03

  The Roth conversion itself generally avoids the early withdrawal penalty, but the money distributed and not converted may not. So that, again, if, if we're pulling out $50,000 to convert, but we're withholding taxes from the $50,000, the money that continues onto the Roth doesn't pay that 10% penalty, but the money that you withheld for the taxes does. That is subject to the 10% penalty. So.

• 9:19Speaker 03

  The solution may seem simple. Well, just pay the taxes with money outside of your IRA. But that's where the second problem comes in. So mistake number two, assuming cash is the only alternative. So let's go back to my inspiration for this episode. A podcast listener who had done extensive research on Roth conversions. She had accumulated substantial retirement savings and was worried about how large her traditional IRA or pre-tax retirement money may become over the next 20 years. And she understood that a Roth conversion could potentially reduce future taxes, but she hadn't been able to make that decision.

• 10:01Speaker 03

  And because mainly she was concerned about getting it wrong, or is this the right strategy? So one of the biggest questions was, how do you pay the taxes? And for this example, imagine someone with approximately $650,000, $70,000 in cash savings and the goal of stopping work or choosing to work or work at a time and a place that they want to be at prior to 60. The woman I spoke with also had a taxable brokerage account. She has done an awesome job accumulating assets. And like most of us, we've done a good job.

• 10:44Speaker 03

  But we want to take the good things we've done and just make them better. How can we take the good things I've done, the decisions I've made, and just make them better? So she also has bonuses, may receive stock compensation, and can save a significant amount from her monthly income each month. So the question isn't simply whether she has enough money to pay the conversion taxes. It's which money should she use? And what does she give up by using that money? So here's what I want you to understand. You can be making good financial decisions individually and still not know whether all of those individual decisions are working together. You might be maxing out your 401K, investing regularly,

• 11:29Speaker 03

  and keeping plenty of cash in savings. And none of those things are wrong. In fact, they're good. But are you saving the right amount? Are you using the right accounts? And will those decisions actually get you where you want to go? That's the difference between managing your money and having a financial plan. And that's exactly the kind of work I do with women at GWA Wealth. If you're doing well financially, but want to know whether everything is working together, you can find out more about working with me through the link in the show notes. Okay, so let's continue using the hypothetical $50,000 conversion and $15,000 tax liability.

• 12:11Speaker 03

  So first option to pay these taxes is to use cash savings. What happens? Your cash falls from 70-ish thousand dollars to $55,000. So what to consider? Do you still have enough money for emergencies and near-term goals? In this case, probably. But what if instead of having 70,000, she really had $20,000 in cash? And she wanted to pay the tax out of the cash to avoid the 10% penalty? Does she then have enough money for emergencies and near-term goals? Probably not, right? Because what should our emergency fund be? Three to six months of expenses?

• 12:55Speaker 03

  Okay, so in that example, do you have enough cash left over? Another option, sell taxable investments. So that preserves your cash, but then you're creating capital gains tax and a smaller Freedom Fund. So the Freedom Fund I talk about a lot, that's that money that we use for the future, whether it's stopping work before 60 for retirement age, or buying a home, or scaling back on work, starting a business. It gives us freedom, right? So if instead we use $15,000 from our taxable investments,

• 13:37Speaker 03

  we then are creating a potential capital gains tax, and again, making our Freedom Fund that much smaller. So that's the con. The pro is that it preserves the bank savings. So here's another option. Use a bonus or restricted stock proceeds. Again, preserves existing savings, preserves your brokerage account, but then there's less money available for other goals. And then there's potential tax consequences for using those funds or those stocks. Here's another option. Increase your paycheck withholding. So instead of using your standard deduction, move your deductions to zero and/or also elect to hold a little bit more from your paycheck.

• 14:22Speaker 03

  So then you pay more tax through your payroll. So that's how we're addressing the tax consequence. Because remember, all of this gets settled up when we're filing our taxes in March and April. So we're getting settled up then. So it's not as if we need to pay the tax immediately. When the conversion happens, we're settling up our taxes then. So by paying more through payroll, you're contributing to the tax liability bit by bit for the rest of the year. The con is that it reduces the take-home pay that you have now, which then could reduce the amount of savings that you have each month. The next option, let's use our monthly savings.

• 15:03Speaker 03

  So instead of saving more money into our investment accounts, into our Freedom Fund, we just use that money and set it aside for the taxes. So that funds your taxes over time. The con of it is it slows the progress towards other goals. Another option, convert a smaller amount, which then creates a smaller tax bill. The con, less money reaches the Roth. The last option, wait to convert. It preserves your current resources, but then your future tax circumstances are uncertain. So what if you end up getting a promotion next year with a big raise and you're ending up in a different tax bracket? So that's where we don't know what's going to happen next year to our tax bracket.

• 15:47Speaker 03

  So if we wait, we're not taking advantage of what we know now, which is a potentially lower tax bracket. So all of these options aren't mutually exclusive. Someone could use part of their bonus, increase the paycheck withholdings, and cover the remainder with savings, right? All that matters is that the IRS gets their money that they are owed, right? So let's talk about funding the taxes versus paying the IRS. So you may not necessarily have to write a check for the entire conversion tax liability on the day you convert. Taxes can be paid through withholding, through estimated payments, or a combination, subject to your tax deadlines and requirements.

• 16:31Speaker 03

  But those payments still have to come from somewhere. So increasing paycheck withholding, for example, doesn't eliminate the financial cost. It just reduces the money available in your paycheck. So using outside funds, from my perspective, is often preferable to taking a potentially penalized IRA distribution. But that doesn't mean someone should automatically use cash. If that cash is needed for an emergency fund, a career transition, or a home purchase, the trade-off could be significant, right? If you're planning on changing jobs within the next year or two, or if you don't have enough money in your emergency fund due to paying the cash for the taxes, or you plan on buying a home next year,

• 17:15Speaker 03

  it may not be worth it to you to do the convert and pay the taxes out of your cash. So how do we know whether using $15,000 of savings is actually a problem? So are we depleting our emergency fund or just using excess cash? This is where we need to evaluate the actual financial situation. Someone that has $68,000 in cash and uses $15,000 to pay Roth conversion taxes, that leaves $53,000. Is that a problem? Not necessarily. Many of you are saying, that's how much cash I have now. Or I don't have that much right now. So $53,000 doesn't sound like a problem to me.

• 18:00Speaker 03

  And it may not necessarily be a problem. It just depends on how much cash you need and what that cash was intended to accomplish and when. So let's talk about what would we evaluate when deciding, should I use cash or use the IRA money for the conversion? Increase my payroll tax? So what would we evaluate? One, how many months of expenses does your emergency fund cover? Two, how stable is your employment? Or even how stable is your income? Are you in a sales-based job where you get mostly commissions? So your income is lumpy and you need that cash to help smooth things out?

• 18:44Speaker 03

  Did your company recently get acquired? And maybe questioning, is my position going to be eliminated?

• 18:52Speaker 03

  Do you have dependents or other financial obligations? Are you anticipating a major expense? A home renovation, a home purchase, a new car purchase? Whatever is something major coming up soon? How much money do you need available to feel comfortable leaving your job in the future? So here's the key takeaway. We cannot determine whether someone can afford a Roth conversion tax bill simply by looking at their bank account balance. There are way more things to consider. So now are we optimizing taxes at the expense of our financial goals? This is a central financial planning discussion. When someone wants to do a Roth conversion,

• 19:37Speaker 03

  that means we want more tax-free retirement assets. So we're thinking about how much our traditional IRA might grow and how much tax we could eventually owe. But let's go back to my conversation. She also wanted to become work optional at 55. She also already had substantial Roth savings. So she wasn't starting from zero when it came to tax diversification. Like I said earlier, she is already doing a really awesome job. She was building up her Freedom Fund. She was saving certificate money each pay. She already had substantial Roth savings.

• 20:18Speaker 03

  She, yes, did have a good chunk of pre-tax 401K. And again, that's not a bad thing. She was diversified as the way her money is treated tax-wise and the liquidity of it. So here are some questions I ask. What is the purpose of the cash that's being accumulated? How much do you need to keep accessible to feel comfortable changing careers? How much do you need in your taxable brokerage account to support you in work optional years? If we were to direct $15,000 towards the conversion taxes, what other savings or investments are we giving up?

• 21:01Speaker 03

  Would you be better served by a smaller conversion, a different conversion year, or no conversion at all? Let's quantify the opportunity cost. Using $15,000 today instead of investing it towards her Freedom Fund. So taking $15,000 of cash that maybe would have been in her Freedom Fund or stop contributing to her Freedom Fund until her $15,000 is paid back, that $15,000 could hypothetically grow to approximately $26,900 over 10 years at a 6% annual return. That doesn't mean the Roth conversion necessarily cost her $26,900 in lost wealth.

• 21:47Speaker 03

  That conversion itself could generate future tax benefits, and those do need to be evaluated. But it demonstrates that money used to pay conversion taxes has another potential purpose. So the goal isn't to just maximize the amount of money in a Roth IRA and get as much money in Roth IRA as possible. The goal is to make financial decisions that support the life you want. And sometimes that means prioritizing tax-free retirement savings. Other times, it means maintaining cash reserves, building a taxable investment account, or keeping enough flexibility to leave a job before traditional retirement age. A financial planner's job is to evaluate how those decisions work together.

• 22:31Speaker 03

  That is what comprehensive financial planning addresses. How taxes, retirement accounts, accessible investments, cash reserves, and career goals fit together. You can research a Roth conversion and understand every rule, but still need help determining whether it's the right decision for your overall plan. So here are the most common questions people ask me about Roth conversions. One, how much should I convert? There isn't a universal dollar amount or percentage that's appropriate for everyone. The amount depends on your current income, your tax bracket, your existing retirement accounts, expected future tax situation, and the ability to pay those taxes.

• 23:15Speaker 00

  This episode is brought to you by Google Chrome. You think you know a browser, but Gemini and Chrome, that's new. It can help you with practically anything on the web, like restoring a vintage motorcycle from a 50-page restoration blog, or finally break down that long article you've had open for weeks. Gemini and Chrome is here for it. Ready to make anything online make sense? There's no place like Chrome. Check responses set up required. Compatibility and availability varies, 18 plus.

• 23:40Speaker 03

  A tax projection can estimate the cost of converting different amounts. Does your income matter when considering Roth conversions? Yes, it does. Although there isn't an income preventing Roth conversions, the conversion increases taxable income when pre-tax funds are converted. So a larger conversion can push your income into a higher marginal tax bracket. It can also affect other tax calculations and income-based costs depending on your circumstances. So does my state matter? Absolutely. If you live in a state with significant income taxes, the state tax liability can meaningfully increase the cost of converting.

• 24:24Speaker 03

  Someone planning to move to a lower tax state may have a different calculation than someone planning to remain in a high tax state. Should I wait until retirement to convert to my Roth IRA? Possibly. Some people experience lower income years between leaving work and beginning Social Security or required minimum distributions. Those years can create opportunities for Roth conversions at potentially lower tax rates. But waiting isn't automatically better. Future tax rates, investment growth, and retirement income are uncertain. Does having existing Roth money matter? Yes. Someone whose retirement savings are entirely pre-tax

• 25:08Speaker 03

  may have different tax diversification needs than someone who already has substantial Roth assets. If you already have significant Roth savings, that is an important part of your overall picture. Can I undo a Roth conversion? So if I realize, oh, my gosh, I did this Roth conversion. Now I'm having cold feet. I don't want to use my cash. I don't really have anything extra to give out of my paycheck. Can I undo it? Generally, no. Under current law, completed Roth conversions cannot be recharacterized back into traditional IRAs. So that makes planning before the conversion especially important. What if my traditional IRA contains after-tax money?

• 25:50Speaker 03

  If someone has nondeductible traditional IRA contributions or other after-tax IRA basis in their traditional IRA, the entire conversion may not be taxable. The IRA aggregation and prorata rules apply. So for examples in this episode, we're assuming the traditional IRA contains entirely pre-tax funds. Let's talk about the two potential tax penalties you may have. The penalty number one is the 10% early distribution tax. And that's what I've spent most of the time talking about today. This may apply when someone under 59 and 1/2 takes money from a traditional IRA and doesn't convert it, unless an exception applies.

• 26:35Speaker 03

  For example, withholding $15,000 from a traditional IRA distribution to cover conversion taxes could result in an additional $1,500 tax. Penalty number two. Estimated tax underpayment penalties. A Roth conversion can create a significant additional tax liability. If you haven't paid enough through withholding or timely estimated payments, you may owe an underpayment penalty. For federal taxes, common safe harbor rules generally allow taxpayers to avoid underpayment penalties by paying enough to satisfy the smaller of 90% of current tax year

• 27:18Speaker 03

  or 100% of prior tax year, with the prior percentage increasing to 110% for certain high-income taxpayers. There are other exceptions and timing rules that apply, and state requirements can differ as well. So maintaining a safe harbor doesn't necessarily mean you've paid the entire tax liability created by the conversion. You might avoid an underpayment penalty and still owe a substantial balance when you file your tax return. So the practical takeaway is estimate the conversion tax before executing the transaction and coordinate the payment strategy with a qualified tax professional.

• 28:01Speaker 03

  Roth conversions can be a valuable tax planning strategy. They can help you manage future taxable income and potentially create more tax-free retirement income. But before converting, you need to understand three things. One, how much tax the conversion will create. Two, where the money to pay that tax will come from. And three, whether paying those taxes interferes with your other financial goals. You don't want to create an avoidable penalty by withdrawing money from your IRA. But you also don't want to avoid that penalty by draining your savings. You need to protect yourself or create the freedom in your life. A smart tax decision isn't always a smart financial decision.

• 28:45Speaker 03

  Your money has more than one job, and your financial plan needs to account for all of them. Thank you so much for joining me today. Again, if you have a question for me or if you want to talk out an idea, use the link in the show notes, schedule some time with me, or send me an email with your question, and I can answer it on the show. shari@shes talking money.com. GWA Wealth is a registered investment advisor. This content is educational and not individualized advice.

• 29:25Speaker 01

  They're running a Cover 2 defense. But you're running to get game day deals on Uber Eats. Keep everyone at tonight's watch party fed with deals from your go-to restaurants. Or stock up with deals on your favorite snacks and groceries. Whatever the occasion, get game day deals on Uber Eats all season long. It's not football without food. Uber Eats, order now. Terms apply. Product availability varies by region. See app for details.

• 29:56Speaker 02

  This episode is brought to you by State Farm. Football has a play for just about everything. You can go deep, keep it on the ground, or draw up something nobody sees coming. And whether you want to run a flea flicker or the tush push, you need a plan to fit your unique situation. That's why State Farm takes the time to get to know you so they can help personalize coverage for your life and budget. Now that's a solid game plan. Like a good neighbor, State Farm is there.