Should You Do a Roth Conversion? Key Factors to Decide

A Roth conversion moves funds from a pre-tax retirement account, like a Traditional IRA or 401(k), into a Roth IRA. This transaction is a fundamental shift in how the funds are taxed. You agree to pay income taxes on the converted amount in the current year. In exchange, the funds can grow and be withdrawn in retirement completely free of federal income tax, provided withdrawal rules are met.

This decision to prepay taxes is a strategic one. Unlike annual Roth IRA contributions, conversions have no income limitations, so anyone can do one regardless of income. The process effectively locks in your current tax rate on the converted funds. This upfront tax payment is the cost of securing tax-free income during your retirement years.

Key Factors for Your Decision

The primary consideration is comparing your current income tax rate to your expected rate in retirement. If you anticipate being in a higher tax bracket during your retirement years, converting now at a lower rate can be advantageous. Scenarios that might create a temporarily lower income include a gap in employment, a sabbatical, or the initial years of a new business.

Conversely, if you expect your income and tax bracket to be lower in retirement, a conversion may be less beneficial. This could be the case if you are at your peak earning years and plan to live on a smaller budget after you stop working. The goal is to pay the conversion tax at the lowest possible rate.

A significant element is the source of funds used to pay the conversion tax. It is highly advisable to use money from a non-retirement account, such as a checking or savings account, to cover the tax liability. Using a portion of the converted funds to pay the taxes reduces the total amount moved into the Roth IRA, diminishing future tax-free growth.

If you are under age 59.5, using retirement funds for the tax payment could also be treated as an early distribution. This may subject that amount to a 10% penalty on top of the ordinary income tax. Paying the tax with outside money preserves the full value of your converted retirement assets.

The amount of time until you plan to begin withdrawals is another important factor. A longer time horizon provides more years for the tax-free growth within the Roth IRA to compound and outweigh the initial tax cost of the conversion. If you convert at a younger age, your investments have decades to grow without the drag of future taxes on earnings.

For those nearing retirement, the calculation is more nuanced. With fewer years for tax-free growth to accumulate, the benefit of avoiding future taxes might not be enough to offset the immediate tax payment. A shorter time horizon demands a more certain expectation of higher future tax rates to make the conversion worthwhile.

Roth IRAs offer distinct advantages for estate planning. Unlike traditional IRAs, the original owner of a Roth IRA is not required to take required minimum distributions (RMDs). For traditional accounts, these mandatory withdrawals begin at age 73 for individuals born between 1951 and 1959, rising to 75 for those born in 1960 or later. The absence of RMDs allows the Roth IRA to grow tax-free for the owner’s life.

When a Roth IRA is passed to a beneficiary, that heir can generally take distributions from the account tax-free. For most non-spouse beneficiaries, the account must be fully withdrawn within 10 years. This contrasts with an inherited traditional IRA, where beneficiaries must pay income tax on all withdrawals.

A large conversion can have immediate financial consequences beyond the tax bill. The taxable income from the conversion is added to your other income for the year, which could push you into a higher marginal tax bracket. This means a portion of your income could be taxed at a higher rate than you anticipated.

This income spike can also lead to increased Medicare Part B and Part D premiums, which are subject to the Income-Related Monthly Adjustment Amount (IRMAA) based on your income from two years prior. On the other hand, converting funds reduces your traditional IRA balance, which will lower your future RMDs. Lower RMDs mean less taxable income in retirement.

Calculating the Tax Cost

The first step in calculating the tax cost is to determine the taxable portion of the conversion. For most individuals whose traditional accounts were funded exclusively with pre-tax contributions, the entire amount you convert is considered taxable income. This amount is added to your other sources of income for the year and is taxed as ordinary income, not capital gains, at federal and state levels.

A more complex situation arises if you have made after-tax, or nondeductible, contributions to any of your traditional IRAs. The IRS requires you to use the pro-rata rule, which prevents you from selectively converting only after-tax money. Any conversion is treated as containing a proportional mix of your pre-tax and after-tax funds. To apply the rule, you must aggregate the balances of all your Traditional, SEP, and SIMPLE IRAs as of December 31 of the conversion year.

For example, you have a total of $100,000 across all your traditional IRAs, of which $20,000 came from nondeductible contributions. The after-tax portion is 20% of your total IRA assets. If you convert $50,000 to a Roth IRA, the pro-rata rule dictates that 20% of that conversion, or $10,000, is tax-free, while the remaining $40,000 is taxable. This calculation is formally completed using IRS Form 8606.

Navigating Special Conversion Rules

When you convert funds, those specific dollars are subject to a five-year holding period. If you withdraw any of the taxable converted principal before five years have passed and you are under age 59.5, that portion may be subject to a 10% early withdrawal penalty. Each conversion transaction has its own separate five-year clock, which begins on January 1 of the year the conversion was made.

A separate five-year rule applies to the earnings generated within your Roth IRA. For any withdrawals of earnings to be a qualified, tax-free distribution, two conditions must be met. First, you must be over age 59.5 or meet another exception. Second, a five-year period must have passed since the first day of the tax year for which you first made any contribution or conversion to any Roth IRA.

There is a specific rule regarding the interaction between Roth conversions and required minimum distributions (RMDs). If you are of the age where you must take RMDs, you cannot convert any portion of your current year’s RMD amount. The RMD must be taken first. After you have satisfied your RMD for the year, you are free to convert any of the remaining balance.

The Roth Conversion Process

Before initiating a Roth conversion, gather the account number for the traditional retirement account you are converting from and the account for the Roth IRA that will receive the funds. You should also have personal identification information available. Finally, you must decide on the exact dollar amount or specific assets you wish to convert and have a plan for paying the taxes.

There are three primary methods for moving the money:

• A trustee-to-trustee transfer, where you instruct your financial institution to move the funds directly to the Roth IRA account. This is the most common method.
• A 60-day rollover, where you receive a check and have 60 days to deposit it into a Roth IRA. Failing to meet the deadline can result in the funds being treated as a taxable distribution and may incur a 10% penalty if you are under 59.5.
• A same-trustee conversion, which is a simple internal transfer if both your traditional and Roth IRAs are at the same institution.

After you complete a Roth conversion, the financial institution that held your traditional IRA will send you Form 1099-R. This form reports the total distribution to the IRS. You are responsible for reporting the conversion on your federal income tax return using Form 8606. The taxable amount from Form 8606 is then transferred to your Form 1040 and included in your gross income.