Making Sense of Roth Conversions

One strategy that can help manage that impact is a Roth conversion. It’s a financial move that can offer long-term tax benefits, but it’s not the right fit for everyone. Let’s break it down in simple terms.

What Is a Roth Conversion?

A Roth conversion means moving money from a traditional retirement account—like a traditional IRA or a 401(k)—into a Roth IRA. When you do this, you pay taxes on the amount you convert. But once the money is in the Roth IRA, it grows tax-free, and qualified withdrawals during retirement are also tax-free.

The main idea is to pay taxes now, so you don’t have to pay them later—especially if you expect to be in a higher tax bracket in the future.

Why Consider a Roth Conversion?

There are a few reasons why someone might consider converting to a Roth IRA:

1. Tax-Free Growth and Withdrawals
   After the conversion, any future growth in your Roth IRA is not taxed. When you take the money out in retirement—if done correctly—it’s tax-free.
2. No Required Minimum Distributions (RMDs)
   Unlike traditional IRAs, Roth IRAs do not have RMDs during the original account holder’s lifetime. This gives you more flexibility with how and when you use your retirement savings.
3. Potential Tax Savings Over Time
   If you expect tax rates to rise or if you expect your own income to increase in the future, converting to a Roth now can mean you pay less in taxes overall.
4. Estate Planning Advantages
   Leaving a Roth IRA to your heirs can be more tax-efficient than a traditional IRA. Beneficiaries will still have to withdraw the funds over a certain period, but they won’t owe income tax on the distributions.

Important Considerations

Before moving ahead with a Roth conversion, here are some key points to keep in mind:

o You Will Owe Taxes Now
The money you convert counts as income in the year of the conversion. That could push you into a higher tax bracket for the year, depending on how much you convert.

o You Need to Plan for the Tax Bill
Ideally, you want to pay the taxes owed with money from outside the account. Using the funds from the retirement account itself can reduce the long-term benefit of the conversion. Keep in mind that a mandatory 10% federal tax is withheld at the time of conversion by the financial institution.

o Timing Matters
Converting during a year when your income is lower than usual can make the tax impact more manageable. Some people choose to convert gradually over several years to avoid a large one-time tax hit.

o Five-Year Rule
The 5-year rule is that the ordering rules for Roth IRA distributions is contributions come out first without any tax or penalty at any age you then have the 5 year wait period on the earnings. If you’re under age 59.5, it’s important to understand the details of this rule. If an individual has had their Roth IRA for five years from the first day of the year they first contributed or converted to any Roth IRA and attained age 59.5, or death or disability has occurred, all distributions are tax- and penalty-free and ordering rules are not relevant.

Who Might Benefit?

Roth conversions can be a smart move for people who:

o Expect to be in a higher tax bracket in retirement

o Want to reduce future RMDs

o Are early in retirement or between jobs and have temporarily lower income

o Have money outside of retirement accounts to pay the taxes due at conversion

o Want to leave tax-free assets to their heirs

Final Thoughts

A Roth conversion can be a powerful tool in your retirement strategy, but it requires careful planning. The tax bill today can be worth it in the long run—but only if it fits with your overall financial picture. It’s not a one-size-fits-all strategy, so it’s important to evaluate your goals, income, and tax situation before deciding.

Working with a financial advisor can help you determine whether a Roth conversion is a good fit for your retirement plan and how to implement it in the most efficient way.