Ever stared at your retirement accounts and wondered if you’re making the most of your money?
If you’ve heard people talking about Roth conversions but felt lost in the financial jargon, you’re not alone.
With so many retirement strategies out there, it’s easy to feel overwhelmed.
But don’t worry – I’m here to break down everything you need to know about how to do a Roth conversion, in plain English.
By: William Hinder, EA | January 30th, 2025
So, you’ve been hearing about Roth conversions and wondering if it’s the right move for your retirement strategy?
A Roth conversion can be a smart way to manage taxes in retirement if you currently have a large amount of pre-tax savings.
Let’s break down how it works and if it could be right for you…
Think of a Roth conversion like changing the timing of when you pay taxes on your retirement money.
In simple terms a Roth conversion involves, taking money from a traditional retirement account (where you haven’t paid taxes yet) and moving it to a Roth account (where you pay taxes now but never again, once a few conditions are met.).
The key difference is pretty straightforward: traditional retirement accounts let you delay paying taxes until retirement, while Roth accounts ask for the tax payment upfront but then give you tax-free growth and withdrawals later.
While this might seem like an easy choice, there are nuances to consider.
The US tax system is progressive, meaning you pay higher tax rates as your income rises.
When you do a Roth conversion, you’re triggering income taxes on the converted amount in the current year.
This could potentially bump you into a higher tax bracket, so carefully analyzing the timing and the amount you convert is critical before taking action.
One of the biggest reasons people consider Roth conversions is the idea of tax diversification.
If you have a significant amount of your savings in pre-tax accounts and you believe your tax rate will be higher in retirement, due to RMDs or other income, then converting some of that pre-tax money to a Roth account now could be advantageous. (See our article about “How to Lower Taxes in Retirement” by clicking here.)
Think of it as hedging against future tax hikes.
It’s important to understand that the tax benefits of a Roth conversion GROW over time. The longer your timeline for the Roth account to grow, the more potential tax savings you’ll see.
Before you jump into a Roth conversion, there are several things you’ll need to think about.
It is NOT a one-size-fits-all decision.
#1. Your current and expected future tax rates: This is the big one. Do you think your tax rate will be higher or lower in retirement?
If it’s going to be lower, then a conversion might not be ideal. Consider both your ordinary income tax rate and the Medicare surtax.
#2. Your investment portfolio: The growth potential of your assets will impact the benefits of Roth conversion, so it’s important to consider how different asset classes in your portfolio might grow.
#3. Your beneficiary’s tax bracket: If you plan to leave the money to your heirs, their potential tax bracket will play a role in whether a conversion makes sense.
#4. How you will pay taxes on the amount converted: The converted amount is treated as ordinary income in the year of the conversion.
It is often most advantageous to pay the taxes with funds from a taxable account rather than from your pre-tax retirement account to manage the tax impact. For even more tax efficiency use assets with the lowest after-tax returns.
Using pre-tax funds to pay the taxes erodes the value of the Roth conversion, although you may still benefit if you have a long enough time horizon.
#5.The timing of your conversion: The best time to consider a Roth conversion is when you have lower potential taxes on the amount converted, such as during a year with lower-than-expected income.
#6. How you intend to use the Roth balance: Are you going to use the money yourself, or do you plan on passing it on to an heir?
#7. Are there more tax-efficient ways to use your pre-tax balance based on your goals?: It is important to evaluate your specific situation and consider ALL tax planning opportunities.
#8. When you’ll need the money: If you’ll need the money within 5 years, a Roth conversion may not be the best strategy.
#9. Do you use income-based programs: Roth conversions can impact the amount you pay or receive from income-based programs such as Medicare, financial aid, or ACA subsidies.
Increasing your income with Roth conversions could reduce your eligibility for programs like these.
While Roth conversions can be extremely beneficial, they’re not always the best choice.
Here are some scenarios where you might want to avoid a Roth conversion:
You expect to be in a lower tax bracket in retirement: If you think your income will drop in retirement, you could end up paying more in taxes by doing a Roth conversion.
You are moving to a lower-tax state: Relocating to a state with lower taxes might make a Roth conversion less advantageous.
You are subject to the Medicare surtax: If you are subject to the 3.8% Medicare surtax due to high income, that’s another factor to consider.
Your beneficiaries are in a low tax bracket: If your beneficiaries are in a low tax bracket, the cost of conversion may not be justified.
You will need distributions from the Roth IRA within five years of converting: If you will need the funds from the Roth IRA within five years, a Roth conversion may not be advantageous.
There’s a 5-year waiting period after a conversion before you can access the converted funds penalty-free. This rule exists for each conversion you make, so timing is crucial if you think you’ll need the money soon.
You are charitably inclined: If you have assets in a traditional retirement account and plan on transferring them to a qualified charitable organization at your death, a Roth conversion offers no advantage. You may want to make Qualified Charitable Distributions (QCDs) during your lifetime instead.
Limited cash for taxes: If paying the conversion tax would force you to use pre-tax funds, it might not be worth it. The math usually works better if you can pay the taxes with non-retirement money or from taxable accounts.
Let’s cut to the chase – if you’ve read this far, you’re serious about optimizing your retirement strategy. Here’s exactly what you should do next:
#1. Run Your Numbers: Pull out your latest retirement account statements and tax returns. What’s your current tax bracket? How much do you have in traditional IRAs or 401(k)s? These numbers are your starting point.
#2. Create Your Timeline: Map out your next five years. Are you expecting any major income changes? Planning to move states? Starting a business? These life changes could create perfect windows for a Roth conversion.
#3. Talk to the Experts: This isn’t a DIY project. Book an appointment with both your financial advisor and/or tax professional. They’re like your financial architects – they can build a conversion strategy that fits your specific situation and make sure it gets done right.
*Pro Tip: Consider a Partial Conversion: Instead of converting everything at once, you might want to consider converting smaller amounts over several years. This strategy can help manage the tax impact of the conversion as well as taking advantage of lower tax brackets before other income sources begin later in retirement.
So, is a Roth conversion right for you?
Here’s what I tell my clients: don’t get caught up in what everyone else is doing.
Your retirement strategy should be as unique as your families’ wealth goals. A Roth conversion isn’t about following trends – it’s about making a calculated decision that could significantly impact your financial future.
Without proper analysis, you could inadvertently incur higher taxes or restrict access to income-based programs.
With all of the moving parts of a Roth conversion strategy, it is helpful to have a financial professional review of your tax returns and overall financial plan to identify if this tax planning opportunity could work for you.
Ready to take control of your retirement tax bill?
Get your free retirement analysis today to see if a Roth conversion strategy could work for you.
