When Does It Make Sense to Do a Roth Conversion?

A Roth conversion is the process of moving funds from a pre-tax retirement account, such as a Traditional IRA or 401(k), into a post-tax Roth IRA. This transaction requires you to pay income tax on the converted amount in the year the conversion takes place. The decision rests on a trade-off: paying taxes on your retirement savings now for tax-free growth and withdrawals in the future. This strategy is available to all individuals, regardless of their income level, and involves a calculated bet that future income tax rates will be higher than your current rate.

Comparing Your Tax Rate Now Versus in Retirement

The decision to execute a Roth conversion hinges on a comparison of your marginal tax rate today versus your anticipated rate in retirement. A conversion is most advantageous when you expect to be in a higher tax bracket during your retirement years than you are currently. This means you would pay taxes on the converted amount at your present, lower rate, avoiding a higher tax rate on withdrawals later in life.

Several factors can influence your future tax situation. Future required minimum distributions (RMDs) from any remaining pre-tax retirement accounts, like a 401(k) or traditional IRA, are a primary consideration. These mandatory withdrawals begin at age 73 and are taxed as ordinary income, which can increase your taxable income in retirement. The age for these distributions is scheduled to rise to 75 in 2033.

Pensions and Social Security benefits also contribute to your retirement income profile. Up to 85% of your Social Security benefits can be subject to federal income tax, depending on your combined income level. The combination of RMDs, pension payments, and taxable Social Security benefits can place a retiree in a higher tax bracket than they experienced during their working years.

Consider a resident physician in a low-income training year who anticipates becoming a high-earning specialist. Converting funds during these lower-income years allows them to pay taxes at a rate of 12% or 22%, rather than the 32% or higher bracket they might face in retirement. Conversely, an individual at their peak career earnings who expects a lower income in retirement might find a conversion less appealing, as they would pay taxes at a high rate now.

The analysis should also account for potential changes in tax legislation. The tax rates established by the Tax Cuts and Jobs Act of 2017 are set to expire at the end of 2025, with rates scheduled to revert to higher levels in 2026 unless new legislation is passed. This creates a window where converting before 2026 could lock in the current, lower rates. For example, a married couple with $140,000 in taxable income is in the 22% bracket, whereas in 2026, that same income level could be subject to a 25% rate.

Financial and Timing Considerations

A primary requirement is having sufficient cash available in a non-retirement account, such as a savings or brokerage account, to cover the income tax liability generated by the conversion. Using funds from the retirement account itself to pay the taxes is disadvantageous. This action is treated as an early withdrawal, which is not only taxable but may also be subject to a 10% penalty if you are under age 59 ½.

The time horizon until retirement is another factor, as the benefits of a Roth IRA’s tax-free growth are magnified over longer periods. You must also consider two distinct five-year rules to avoid taxes and penalties. For a withdrawal of earnings to be tax-free, your first contribution to any Roth IRA must have been made at least five years prior. Separately, if you are under age 59½, a 10% penalty may apply to the taxable portion of a conversion if withdrawn within five years of the conversion event, as each conversion has its own five-year clock.

Strategic timing related to market conditions can also enhance the benefits of a conversion. Executing a conversion during a stock market downturn can be advantageous. When the market is down, the value of the assets in your traditional IRA or 401(k) is lower, resulting in a lower overall tax bill. This allows the subsequent market rebound and future growth to occur entirely within the tax-free environment of the Roth IRA.

Navigating the Pro-Rata Rule with Existing IRAs

The pro-rata rule is a technical hurdle for many considering a Roth conversion. This IRS regulation applies if you have both pre-tax and post-tax (non-deductible) contributions in any of your traditional, SEP, or SIMPLE IRAs. The rule prevents you from selectively converting only the non-taxable, post-tax dollars, as any conversion is treated as a proportional distribution of both.

To determine the taxability of a conversion, the IRS requires you to aggregate the value of all your non-Roth IRAs. The calculation involves determining the percentage of your total IRA assets that consists of post-tax contributions. That same percentage is then applied to your conversion amount to determine how much of it is non-taxable. The remainder is considered to have come from pre-tax funds and is subject to income tax.

For example, an individual has a total of $100,000 in their traditional IRAs. Of this total, $80,000 came from pre-tax contributions, while $20,000 came from post-tax contributions. In this scenario, 80% of the total IRA balance is pre-tax, and 20% is post-tax. If this person decides to convert $30,000 to a Roth IRA, the pro-rata rule dictates that 80% of that conversion ($24,000) will be taxable income, and 20% ($6,000) will be tax-free.

This aggregation rule applies to the total balance of all of an individual’s traditional, SEP, and SIMPLE IRAs as of December 31 of the year the conversion is made. You cannot isolate one IRA with only non-deductible contributions and convert it tax-free if you have other IRAs with pre-tax funds. Understanding your total IRA composition, as reported on IRS Form 8606, is a necessary step.

Roth Conversions as an Estate Planning Tool

A Roth conversion can also serve as an estate planning strategy for transferring wealth. One of the primary benefits is that Roth IRAs are not subject to Required Minimum Distributions (RMDs) for the original account owner. This contrasts with traditional IRAs, which mandate that owners begin taking taxable withdrawals at a certain age, depleting the account.

The absence of RMDs allows the assets within a Roth IRA to continue growing tax-free for the owner’s life. This can lead to a larger inheritance for beneficiaries compared to a traditional IRA that is continuously drawn down by RMDs. By converting, you prepay the income tax, allowing a larger pool of assets to compound without forced distributions.

This strategy also benefits beneficiaries. While distributions from an inherited Roth IRA are income-tax-free, most non-spouse beneficiaries must withdraw all funds from the account within 10 years. The specific withdrawal requirements depend on whether the original owner died before or after their own RMDs were set to begin. Paying the income tax during the conversion can also reduce the size of your taxable estate, which could lessen potential federal estate taxes for very large estates.