Roth Conversions: What You Need to Know

Roth conversions come up frequently in retirement planning—and for good reason. Moving money from a tax-deferred retirement account to a Roth IRA can create more tax flexibility later, but the decision isn't simply about whether Roth money is "better."

The more important question is whether paying tax on some of your retirement savings today may put you in a better position over the years ahead.

For many people, the years right before and after retirement can provide an especially valuable opportunity to take a closer look.

What Is a Roth Conversion?

A Roth conversion involves moving money from a traditional IRA or other eligible pre-tax retirement account into a Roth IRA. Because you generally received a tax benefit when the money went into the traditional account, the amount converted that has not previously been taxed is included in your taxable income for the year of the conversion.

In exchange for paying that tax today, the money can continue growing in the Roth IRA, and qualified withdrawals can eventually be taken tax-free. Roth IRAs also don't have required minimum distributions, or RMDs, during the original owner's lifetime, which can provide additional flexibility when deciding where retirement income should come from.

Why Retirement Can Create a Roth Conversion Opportunity

One of the first things we look at isn't simply your tax bracket today, but how we expect your taxable income to change over time. For many retirees, income drops after they stop working. Later, Social Security, pensions, investment income and eventually required minimum distributions may begin filling those lower tax brackets again.

Those years in between can create a planning opportunity. Rather than waiting for a large traditional IRA balance to eventually generate taxable RMDs, it may make sense to intentionally convert portions of the account during lower-income years. The goal isn't necessarily to pay the least tax this year. It's to consider whether paying some tax now could result in a better tax outcome over your retirement.

A Roth Conversion Isn't All or Nothing

Another misconception we hear is that converting to a Roth means moving your entire IRA at once. It doesn't. Partial Roth conversions allow us to choose how much income to recognize in a particular year, and the amount can change from year to year depending on your circumstances.

For example, we might look at how much room remains within a particular tax bracket and whether it makes sense to use some or all of that room for a conversion. A larger conversion may make sense one year, while a smaller conversion—or no conversion at all—may make sense the next. This is why I tend to think about Roth conversions as part of an annual, multi-year tax-planning process rather than a one-time decision.

Roth Conversions as Tax Rate Insurance

One way to think about Roth conversions is as a form of tax rate insurance. By paying taxes at today's rates, you can reduce your exposure to future tax increases, whether those come from changes in your personal tax bracket or changes in federal tax policy. While we can't predict whether Congress will raise tax rates in the future, converting a portion of your traditional retirement savings to a Roth IRA can help hedge against that uncertainty. You're essentially locking in today's tax rates on the amount converted in exchange for tax-free qualified withdrawals in retirement. Of course, that protection comes with an upfront tax cost, so it's important to weigh the taxes paid today against the potential benefits down the road.

Your Tax Bracket Isn't the Only Number That Matters

While tax brackets are an important part of the analysis, they're only one piece of it. A Roth conversion increases your taxable income, which can have ripple effects throughout your financial plan. Depending on your circumstances, additional income could affect the taxation of Social Security benefits, Medicare income-related premiums, certain deductions and credits, and other income-based tax provisions.

Medicare is an especially important consideration because its income-related premium adjustments generally use tax information from two years earlier. Someone approaching or already enrolled in Medicare may therefore want to understand not only the income tax generated by a conversion, but whether it could also increase future Medicare premiums.

That's why simply saying, "I have room left in this tax bracket, so let's fill it," can be too simplistic. We want to understand what the additional income does to the entire tax return and retirement plan.

What About Required Minimum Distributions?

RMD planning is another reason Roth conversions may come into the conversation. Traditional IRAs generally require distributions beginning at the applicable RMD age, while Roth IRAs do not require distributions during the original owner's lifetime.

Converting some traditional IRA assets before RMDs begin can reduce the balance that will eventually be subject to required distributions and may provide greater control over taxable income later in retirement. Once RMDs begin, however, the required distribution itself cannot be converted to a Roth IRA. The RMD generally must be taken first, after which additional eligible IRA dollars may potentially be converted.

Don't Forget About the Five-Year Rules

The five-year rules surrounding Roth IRAs are often misunderstood because there isn't just one rule. One five-year period helps determine when earnings from a Roth IRA can be distributed tax-free. There is also a separate five-year rule for each Roth conversion that can affect the 10% early-distribution penalty when converted amounts are withdrawn before age 59½.

That means being within five years of retirement is not, by itself, a reason to avoid a Roth conversion. Your age, how long you've had a Roth IRA, when you expect to use the converted money and the type of withdrawal all matter. For many retirees who are already over age 59½ and don't expect to immediately spend the converted funds, the five-year rules may be much less restrictive than they first appear.

How Will You Pay the Tax?

If a conversion makes sense, we also need to decide how the resulting tax will be paid. When possible, paying the tax from cash or other non-retirement assets allows the full amount converted to remain invested in the Roth IRA. Using part of the IRA distribution to cover the tax means less money makes it into the Roth and, for someone under age 59½, may create an additional penalty issue.

This is one of the reasons we like to estimate the tax impact before completing a conversion rather than waiting until the tax return is prepared the following spring. We can also consider whether additional estimated tax payments or withholding may be necessary to avoid an underpayment penalty.

Roth Conversions Can Be Part of Estate Planning Too

Your own retirement tax picture isn't the only consideration. Roth assets can sometimes be attractive assets to leave to heirs because qualified distributions are generally income-tax-free. Most non-spouse beneficiaries are still subject to inherited-account distribution rules, but they generally don't owe income tax on qualified Roth IRA withdrawals.

That can make the analysis more interesting. In some situations, it may make sense for a retiree to voluntarily pay tax at today's rate rather than leave an heir a larger traditional IRA that will eventually be taxable at the heir's rate. Of course, that depends on your tax situation, your heirs' circumstances and your overall estate plan.

Once You Convert, You Generally Can't Undo It

Another important point is that Roth conversions completed today generally cannot be reversed, or "recharacterized," back into a traditional IRA. That makes planning the amount particularly important. We don't want to discover after year-end that a conversion was much larger than intended or created an unexpected tax consequence.

The mechanics themselves are usually fairly simple. A conversion can generally be completed through a direct transfer from a traditional IRA to a Roth IRA at the same or a different financial institution. There are other methods available, but a direct transfer is often the cleanest approach because the money moves directly between the retirement accounts.

How Birch Street Thinks About Roth Conversions

We don't think the goal should be to convert as much as possible—or to avoid paying taxes at all costs. The real question is when it makes sense to pay the tax and when it makes sense to defer it.

That means looking beyond this year's tax return. We consider current and future tax brackets, Social Security, RMDs, Medicare premiums, portfolio withdrawals, charitable giving, estate goals and the assets available to pay the conversion tax. For someone approaching or recently entering retirement, we may look many years ahead and ask whether there are lower-tax years available today that we aren't likely to have later.

Sometimes that analysis leads to a Roth conversion. Sometimes it leads to a series of smaller conversions over several years. And sometimes the numbers tell us not to convert at all. The important part is that the decision fits into the larger retirement and tax plan rather than being made in isolation.