If you have saved for retirement in a traditional IRA or 401(k), you have enjoyed a tax deduction on the money going in, but every dollar coming out will be taxed as ordinary income. A Roth conversion flips that arrangement. You move money from a traditional account into a Roth IRA, pay income tax on the amount you convert today, and in return the money can grow and be withdrawn tax-free in retirement. Whether that trade is worth it depends on your tax bracket now, your expected bracket later and how you plan to use the money. Here is how to think it through.
How a Roth conversion works
The mechanics are simple. You instruct your IRA custodian to move some or all of your traditional IRA balance into a Roth IRA, either at the same institution or a new one. The amount you convert is added to your taxable income for that year. If you have only ever made deductible contributions, the entire converted amount is taxable. If you made nondeductible contributions in the past, part of the conversion may be tax-free under the pro-rata rule, which looks at all of your traditional IRA balances together. There is no income limit on conversions, so even high earners who cannot contribute to a Roth directly can convert.
Why paying tax early can pay off
The main reason to convert is the expectation that your tax rate will be higher later than it is now. Once money is in a Roth IRA and you meet the holding rules, qualified withdrawals are completely tax-free, including all of the growth. Roth IRAs also have no required minimum distributions during the original owner's lifetime, so you can leave the money invested as long as you like. That flexibility helps manage your taxable income in retirement, which can affect how much of your Social Security is taxed and what you pay for Medicare premiums. Roth accounts can also be a valuable inheritance, since heirs generally receive the money without owing income tax on it.
When a conversion often makes sense
Conversions tend to work best in lower-income years. Common examples include the gap between retirement and the start of Social Security and required distributions, a year when you are between jobs or on sabbatical, a year with a large business loss or deduction, or early in your career before your income rises. A market downturn can also be an opportunity, because converting while account values are temporarily lower means you pay tax on a smaller amount and the recovery happens inside the Roth. Many people choose to convert a little each year, filling up their current tax bracket without spilling into the next one.
A partial conversion each year, sized to stay within your current bracket, is often smarter than converting everything at once.
When it may not be a good idea
A conversion is less attractive if you are in a high bracket today and expect to be in a lower one in retirement, since you would be paying a higher rate now to avoid a lower one later. It can also backfire if you would need to use money from the IRA itself to pay the tax, because that shrinks the amount growing tax-free and may trigger a penalty if you are under 59 and a half. If you plan to leave your traditional IRA to charity, converting may be unnecessary, since charities do not pay income tax on what they inherit. Finally, a large conversion can raise your Medicare premiums two years later or reduce eligibility for income-based credits, so timing matters.
Rules to know before you convert
Since 2018, a Roth conversion cannot be undone, so it is important to plan carefully before you act. Each conversion has its own five-year clock: if you are under 59 and a half, withdrawing converted amounts before five years have passed can trigger a 10 percent penalty. Earnings in a Roth IRA are tax-free only once you are 59 and a half and your first Roth IRA has been open for at least five years. Conversions also need to be reported on your tax return, and you may need to increase your withholding or make an estimated tax payment so you are not hit with an underpayment penalty.
Building a conversion plan
A good plan starts with a projection of your income and tax brackets year by year, from today through your required distribution age. From there you can see which years have room for conversions and how much to convert in each. Pay the tax from savings held outside your retirement accounts whenever possible, so the full amount keeps growing in the Roth. Coordinate conversions with other moves, such as capital gains, charitable gifts and the timing of Social Security, so they work together rather than against each other.
The bottom line
A Roth conversion is a trade of a known tax bill today for tax-free income tomorrow. It can be one of the most powerful tools for retirement savers, but only when the numbers support it. If you are approaching retirement, have a lower-income year ahead or simply want to know whether converting makes sense for you, the advisors at Capital Growth Point can run a multi-year projection and recommend how much to convert, and when.
