When Does a Roth Conversion Make Sense?

A Roth conversion involves moving pre-tax funds from a traditional Individual Retirement Account (IRA), 401(k), or other eligible retirement accounts into a Roth IRA. This process shifts assets from a tax-deferred status to a tax-free one, by paying taxes on retirement savings now.

Understanding the Tax Impact

The amount converted from a pre-tax retirement account to a Roth IRA is treated as taxable income in the year of the conversion. This means the converted sum is added to your other income, which can increase your current year’s income tax bracket. For example, if you are in the 22% tax bracket, the converted amount will be taxed at that rate, and a large conversion could push some of your income into a higher bracket, such as 24% or more. Financial professionals advise against converting so much that it forces you into an unnecessarily high tax bracket, suggesting smaller, staggered conversions over several years instead.

While the conversion itself triggers an immediate tax liability, qualified withdrawals from the Roth IRA in retirement are entirely tax-free. To qualify for tax-free withdrawals of earnings, the Roth IRA must have been open for at least five years, and the account holder must be age 59½ or older, disabled, or using the funds for a qualified first-time home purchase. This “five-year rule” for earnings begins on January 1 of the tax year you made your first contribution to any Roth IRA. Each Roth conversion has its own five-year holding period for the converted amount. If you withdraw converted funds before age 59½ and before five years have passed since that specific conversion, a 10% penalty may apply to the converted principal.

Situations Favoring a Conversion

A Roth conversion is advantageous when an individual anticipates being in a higher tax bracket during retirement than their current bracket. This strategy allows them to pay taxes on the converted funds at a lower rate now, effectively locking in a lower tax cost for future tax-free withdrawals. Being in a lower-than-usual income year, perhaps due to a sabbatical, unemployment, or early retirement before drawing Social Security or pensions, presents an opportune time for a Roth conversion. Converting during such a period can allow individuals to fill up lower tax brackets with the converted income, minimizing the overall tax burden.

A reason for a Roth conversion relates to estate planning. Unlike traditional IRAs, Roth IRAs do not have required minimum distributions (RMDs) for the original owner during their lifetime. This means the funds can continue to grow tax-free indefinitely, potentially leaving a larger, tax-free inheritance for beneficiaries. Beneficiaries receive tax-free withdrawals from an inherited Roth IRA, though they may be subject to RMD rules, typically requiring the account to be fully distributed within 10 years after the original owner’s death.

Seeking tax-free income in retirement also provides greater flexibility in managing future tax liabilities. By having a portion of retirement savings in a Roth account, individuals can strategically withdraw funds to help manage their adjusted gross income (AGI) in retirement. This can be beneficial for managing the taxation of Social Security benefits or maintaining eligibility for certain income-dependent benefits and credits.

Personal Financial Evaluation

Determining if a Roth conversion aligns with your financial goals requires assessing your individual circumstances. A primary consideration involves comparing your current income level and tax bracket with your projected income level and tax bracket in retirement. If you expect your income to be higher, or tax rates to increase, converting now could lead to significant long-term tax savings. However, if you anticipate a lower income in retirement, the immediate tax cost of a conversion might outweigh the future benefits.

The availability of non-retirement funds to pay the taxes on the conversion is another important factor. It is advisable to pay the taxes from sources outside the converted amount, such as a taxable brokerage account or savings. Paying the taxes directly from the converted funds reduces the amount that can grow tax-free in the Roth IRA and may incur additional taxes or penalties if you are under age 59½.

Your time horizon until retirement and the potential for the Roth account earnings to grow tax-free are also important. The longer the money remains in the Roth IRA, the greater the potential for tax-free growth, making conversions more beneficial for younger individuals or those with a longer time until retirement.

Assess the potential impact of the increased income from a conversion on your eligibility for other tax credits, deductions, or subsidies. For instance, a Roth conversion can temporarily increase your modified adjusted gross income (MAGI), which could affect eligibility for Affordable Care Act (ACA) subsidies or result in higher Medicare premiums through the Income-Related Monthly Adjustment Amount (IRMAA). Medicare premiums are based on your MAGI from two years prior, so a large conversion could lead to increased premiums in the future.

Completing a Roth Conversion

Executing a Roth conversion begins with identifying the specific account or accounts you wish to convert. Funds from traditional IRAs, SEP IRAs, SIMPLE IRAs, and eligible distributions from employer-sponsored plans like 401(k)s, 403(b)s, or governmental 457(b)s can be converted to a Roth IRA. Partial conversions are permissible and can be used to manage the tax impact.

Contact the financial institution where your traditional retirement account is held. They will guide you through their process for initiating a conversion.

Common methods for transferring funds include a direct rollover (also known as a trustee-to-trustee transfer) or a same-trustee transfer. In a direct rollover, the funds are sent directly from your current financial institution to the Roth IRA provider. If both accounts are at the same institution, a same-trustee transfer moves the funds internally. An indirect rollover, while less common, involves you receiving a check and then depositing the funds into a Roth IRA within 60 days.

Accurate tax reporting is a key part of the conversion process. The Internal Revenue Service (IRS) requires the use of Form 8606, “Nondeductible IRAs,” to report Roth conversions. This form tracks any non-deductible contributions made to traditional IRAs and calculates the taxable portion of the conversion. Part II of Form 8606 is used for reporting conversions from traditional IRAs to Roth IRAs. Filing this form ensures the IRS is aware of the conversion and that you are not taxed again on amounts already subject to tax.