If you’re planning for retirement, you’ve likely heard about Roth IRAs. But what about a Roth IRA conversion? This strategy can offer tax benefits if used at the right time.
In this post, I’ll walk you through what a Roth IRA conversion is, when it might make sense, and how to decide if it’s the move for your financial plan.
What is a Roth IRA Conversion?
A Roth IRA conversion is when you move money from a traditional IRA (or a pre-tax 401(k)) into a Roth IRA. When you do this, you pay income tax on the amount you convert—but once the money is in the Roth IRA, it grows tax-free and can be withdrawn tax-free in retirement (assuming you follow the rules).
This is essentially paying taxes now in exchange for tax-free income later.
Why Consider a Roth IRA Conversion?
Here are a few key benefits:
- Tax-Free Growth: Once the funds are in the Roth IRA, all future earnings are tax-free.
- No Required Minimum Distributions (RMDs): Unlike traditional IRAs, Roth IRAs are not subject to RMDs during your lifetime.
- Tax Diversification: Roth conversions add flexibility in retirement, giving you both taxable and tax-free income sources.
- Legacy Planning: Roth IRAs can be powerful tools for leaving tax-free income to your heirs.
When Might a Roth Conversion Make Sense?
Here are scenarios where it might work in your favor:
- You’re in a low tax bracket now: If your income is unusually low this year, it might be a good time to convert at a lower tax cost. Examples: You retired early, took time off work, or had lower than normal business income.
- You expect higher taxes in the future: Whether due to tax policy changes or personal income increases, paying taxes now could be smarter than paying more later.
- You have a long time until retirement: The younger you are, the more time your Roth IRA has to grow tax-free. Early conversions may yield significant benefits over decades.
- You want to reduce future RMDs: Converting now shrinks the balance in your traditional IRA, which in turn reduces your future required distributions (and their tax impact).
- You’re doing strategic tax planning in retirement: Partial conversions each year during retirement can “fill up” lower tax brackets and help spread out tax liability over time.
When to Avoid a Roth IRA Conversion
A Roth conversion isn’t always the best move. Be cautious if:
- You’d have to pay conversion taxes from your retirement account. This is not ideal. You want to use cash (if possible) in order to get the largest amount into the Roth IRA to then grow tax fee.
- You’re in your peak earning years and already in a high tax bracket.
- You’ll need the money soon. Roth IRA conversions come with a 5-year rule for accessing the earnings tax-free.
- It would push you into a higher Medicare premium tier or affect other income-based benefits.
How Much Should You Convert?
You don’t have to convert everything at once. Many of my clients benefit from partial conversions each year, targeting a specific tax bracket (like the 12% or 22%) and coordinating the strategy with their CPA or tax advisor.
Final Thoughts from Your Financial Advisor
A Roth IRA conversion can be a powerful tool, but timing and tax planning is everything. It’s not just about saving on taxes; it’s about optimizing your retirement income and legacy.
Together, we can work to keep you on-track toward your financial goals.
Request a consultation to learn more.
Read more articles by Ryan Johnson