When & Why Do Roth Conversions Make Sense?

Rebecca Luebrecht |

It’s not uncommon for a household nearing or in retirement to have most—or all—of their retirement savings in a pre-tax position in their retirement savings account(s). While you shouldn’t beat yourself up for this, there may be strategies to give you balance and efficiency in your financial plan for the years ahead.  

Enter ROTH CONVERSIONS.  

While you have earned income, you can contribute to a Roth 401(k) or Roth IRA. But it’s not too late EVEN AFTER your income earning years. You can still shift funds from a pre-tax position to a tax-free position via Roth conversions.

Roth IRAs (named after Senator William Roth) came into existence in the late 1990’s when authorized by the Taxpayer Relief Act of 1997. Contributions to these retirement savings accounts receive no preferential tax treatment in the year of funding but allow for tax-deferred growth and tax-free qualified distributions in later years.  

When a conversion takes place, you are taking a taxable distribution from your IRA or 401(k), and instead of transferring it to your bank account, you transfer it to your Roth IRA or Roth 401(k).  

So, why would I want to take a distribution that I don’t need and pay taxes now, you may ask?

  • Roth conversions allow all future growth to occur tax-deferred and then distribute tax-free upon distributions, assuming rules are met for a qualified distribution. (Five-year rules for conversions and distributions can become rather complicated, we suggest consulting with your financial advisor before taking a distribution.)
  • With Roth Conversions, you gain flexibility to manage taxable income later. For larger distribution needs during retirement—such as home repairs, a new car, travel expenses, or big gifts—tax-free distributions from a Roth IRA help control tax brackets, control Medicare premium surcharges (IRMAA), and could minimize taxation of Social Security benefits.
  • If you’re in a lower bracket now, you can “fill up” lower tax brackets with Roth Conversions, by paying today’s “known” tax rate instead of the unknown tax scenarios of the future. Currently, we are in a very low federal income tax environment from a historical perspective. Conversions may be advantageous if you believe your tax rates could increase in the future due to policy changes or household spending. Because of this, some individuals who are still working complete Roth Conversions (but again, it’s best to consult with your financial advisor and tax professional first!).  
  • Traditional IRAs and 401(k)s require you to start Required Minimum Distributions (RMDs) at a certain age. This takes away your individual discretion, and if your account balance is large enough in your pre-tax account, your taxable income may climb into higher marginal tax brackets after you reach RMD age. Roth IRAs (for original owners) don’t have RMDs, and this allows appreciation to grow for longer, giving you the control.
  • Roth IRAs can be a powerful wealth transfer tool as well. If you are married and one spouse outlives the other for many years, completing Conversions early while filing under the married filing jointly status can be an effective hedge against the more restrictive tax filing single status that often occurs later in life for one spouse. This is especially important if you don’t anticipate lifestyle changes after one spouse passes away.  
  • Also, non-spousal individual beneficiaries (many times children) will eventually have 10 years to liquidate IRA accounts that they inherit (under new Secure Act provisions). If you leave Roth funds, those distributions become tax free to your beneficiaries.

There are many reasons to consider Roth conversions. Call your advisor today to see if it is right for you.

A Roth IRA conversion—sometimes called a backdoor Roth strategy—is a way to contribute to a Roth IRA when income exceeds standard limits. The converted amount is treated as taxable income and may affect your tax bracket. Federal, state, and local taxes may apply. If you’re required to take a minimum distribution in the year of conversion, it must be completed before converting.
To qualify for tax-free withdrawals, you must generally be age 59½ and hold the converted funds in the Roth IRA for at least five years. Each conversion has its own five-year period, and early withdrawals may be subject to a 10% penalty unless an exception applies. Income limits still apply for future direct Roth IRA contributions.
This material is for informational purposes only and does not constitute tax, legal, or investment advice. Please consult a qualified tax professional regarding your individual circumstances.