A Roth conversion involves transferring funds from a pre-tax retirement account, like a traditional IRA or 401(k), into a Roth IRA. You pay taxes on the converted amount in the year of the conversion (as if it were your income), but then the money grows tax-free as a reclassified Roth IRA. Qualified withdrawals in retirement remain tax-free.
Why (and when) should you convert?
Melanie Musson, finance expert with Clearsurance.com, said, “A Roth conversion makes sense if you’re young. A Roth IRA is generally more beneficial in the long run due to its tax-free withdrawals. Some people opt for a traditional IRA because of its immediate tax benefits, but if you can afford to pay the taxes on the amount you convert, it makes sense to allow your assets to grow without worrying about paying taxes on the growth.”
If you’re in a lower tax bracket now than you will be in retirement, minimizing your tax obligation is smart, she said. The more of your money that you can keep for your own use, the better. If you don’t want to deal with the required minimum withdrawals (RMDs) associated with a traditional IRA, converting to a Roth IRA makes sense, because you’re never required to withdraw anything.
Something else to consider, said Kevin Quinn, president and founding attorney of Legacy Counselors, P.C., is that if your retirement account grows too large, you may see very high distributions in your late 80s and early 90s, and pay more income tax as a result. If that retirement account nears $1.5 to $ 2 million, switching to a Roth conversion makes good financial sense.
“Physicians and other high-earners may take distributions at age 73 because in their 80s, their tax bracket is higher,” he said. “A Roth conversion allows you to convert a portion of your funds so that you can project into the future. The Roth is also the best gift for your children and grandchildren because it remains tax-free for 10 years after death.”
Consider these factors if you’re thinking about a Roth conversion
- Expectation of higher future tax rates: If you anticipate that overall tax rates will increase in the future (or you know you’ll be in a higher tax bracket after you retire), paying taxes now at your current (lower) rate can save you significantly in the long run.
- Tax diversification: A Roth conversion allows you to have a “tax-free bucket” of money in retirement, in addition to any pre-tax accounts (traditional IRAs or 401(k)) and taxable accounts. This diversification gives you more flexibility to manage your taxable income in retirement. For example, if you needed to take a large withdrawal for an unexpected expense, you could pull it from your Roth IRA without increasing your taxable income, potentially avoiding higher Medicare premiums or a higher tax bracket for your Social Security benefits.
- No required RMDs for the original owner: Unlike traditional IRAs, Roth IRAs don’t carry RMDs during the original owner’s lifetime. Your money can grow tax-free for as long as you live, providing more flexibility for when you need to access funds and allowing for more strategic estate planning.
- Estate planning benefits: Roth IRAs can be powerful estate planning tools. When inherited by beneficiaries (especially non-spouses), Roth IRAs are generally tax-free, provided the account has been open for at least five years. This IRA type offers a significant advantage compared to inheriting a traditional IRA, where beneficiaries must typically withdraw the account’s funds within 10 years and pay taxes on the withdrawals.
- Taking advantage of lower-income years: One strategy is to do a Roth conversion during years when your income is temporarily lower, such as after a career change, early retirement, or a year with numerous tax deductions. Converting in a lower tax bracket can minimize the tax hit of the conversion.
- Avoiding the “backdoor Roth IRA” contribution limits: While Roth IRA contributions have income limits, there are no income limits for Roth conversions. High-income earners can indirectly fund a Roth IRA by contributing to a traditional IRA (which doesn’t have income limits) and then converting it to a Roth IRA via the “loophole” backdoor Roth IRA approach.
Still debating whether to convert to a Roth IRA?
There are several key considerations to keep in mind before converting.
- You must pay taxes on the converted amount in the year of conversion. Ideally, you should pay these taxes with funds outside your retirement accounts, as using money from the conversion itself to pay the taxes reduces the amount that can grow tax-free in the Roth.
- Each Roth conversion has a separate five-year waiting period for tax- and penalty-free withdrawals of the converted amount if you’re under 59 ½ years old. However, if you’re at least 59 ½ and your Roth IRA has been open for at least five years, all qualified withdrawals are tax-free regardless of when the original conversion took place.
- A large Roth conversion can significantly increase your taxable income for the year, which can push you into a higher income bracket for Medicare premiums (Income-related Monthly Adjustment Amount, or IRMAA).
Final thoughts
Converting traditional retirement accounts to an account funded with after-tax dollars plays a massive role in why this conversion is so popular and common, said Peter Reagan, financial market strategist at Birch Gold Group.
Before you take any action, meet with your financial advisor or planner to discuss your retirement goals. If you don’t want to worry about paying taxes while withdrawing money during retirement, Reagan recommends contributing to a Roth IRA while you’re still working—and taking advantage of a conversion if you’re nearing retirement or have just retired.
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