Roth IRA Conversions: What To Know And How To Use Them

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Converting a pre-tax retirement account, such as a traditional IRA, to a Roth IRA is a rather straightforward process that may allow for big tax savings in the future, depending on your circumstances. Here’s an overview.

What Is A Roth conversion?

A Roth conversion involves transferring pre-tax—often referred to as “traditional”—retirement account funds into a Roth account. Roth accounts are post-tax, meaning that you’ve already paid income taxes on what you contribute … and won’t pay income taxes on those contributions when you withdraw funds later. That’s in contrast to traditional accounts, in which you defer income tax on your contributions until withdrawal.

When you convert, you’ll have to pay income taxes—that’s what it means to shift from pre-tax to post-tax dollars.

You can convert various types of pre-tax retirement funds to a Roth IRA. The most familiar conversion is a Traditional IRA to a Roth IRA. But the concept also applies to pre-tax 401(k), 403(b), 457(b), SEP IRA and SIMPLE IRA accounts.

Who Would Benefit From A Roth Conversion?

Roth conversions offer several advantages that can significantly impact your financial future.

  • First, a Roth provides more flexibility. For example, Roth IRAs are not subject to required minimum distributions (RMDs), unlike traditional IRAs. Avoiding RMDs can be especially helpful when you have retirement income from other sources and would prefer to leave the money where it is, still benefiting from tax-free growth within the Roth account.
  • Second, Roth conversions can be an effective tool for estate planning. Often, retirees find themselves in lower tax brackets than their high-earning children. The retirees can pay taxes now and later pass assets tax-free to their beneficiaries. This strategy has become more appealing in the last few years because recent legislation limited non-spouse heirs’ ability to keep funds inside inherited retirement accounts.

How Do You Convert Your Account Into A Roth?

The conversion process itself is relatively simple. The account owner needs to open a Roth IRA and then instruct the custodian of the pre-tax retirement account (whether a Traditional IRA or another type of account) to transfer cash or securities into Roth account.

You don’t have to convert an entire pre-tax account at once. One popular strategy is to convert a portion of a pre-tax account each year for several years to spread out the tax burden. What’s best for you will depend on age, employment status, income, and the tax rate of beneficiaries, and other factors.

One pitfall to avoid is taking money from your Roth account too soon after conversion. The “five-year rule” holds that withdrawals of converted funds made within the first five years following conversion are subject to a 10% penalty unless the account owner is 59 ½ years or older. The five-year period begins on January 1 of the conversion year, and each conversion has its own five-year period.

If the five-year rule is relevant for you, you need to be further aware that Roth IRA withdrawals follow a specific order: contributions are withdrawn first, followed by converted amounts, and then gains. If there are multiple converted amounts, the oldest conversion is withdrawn first.

How Does This Affect Tax Planning?

As mentioned previously, converted amounts are subject to ordinary income tax in the year that they are converted into a Roth account.

One big point is determining where money for taxes due is coming from. If taxes are paid from IRA dollars, this will reduce the size of the IRA itself. To maximize the amount converted—and therefore remaining tax-advantaged—it is generally more beneficial to pay the taxes from outside the IRA. Regardless, paying income taxes due will take time to recoup through tax-deferred growth inside the Roth IRA.

Income tax payment isn’t the only tax consideration though. Before converting, you should also consider the potential impact on your tax situation.

For example, since a conversion involves additional income, it could push you into a higher income bracket. For older adults, this can affect Medicare Part B premiums. So, it’s crucial to evaluate the current tax bracket relative to the anticipated future tax bracket.

Another Medicare-related issue is Income-Related Monthly Adjustment Amount (IRMAA) thresholds. Showing higher income on your tax return could lead to higher premiums (though the tax savings may substantially outweigh premium increases).

Understand The Intricacies

Roth conversions are popular and can benefit people in a wide range of circumstances. They are also straightforward to actually implement. But neither of those facts mean the planning around a conversion is trivial. Avoid pitfalls and optimize your approach by working closely with your financial advisor to find the strategy best for your circumstances.

About the Author

Bob Schneider, CFP, RICP® is a SVP Director of Financial Planning, Wealth Advisor at Johnson Financial Group. Bob specializes in providing clients with the educational information and tools necessary to make informed decisions regarding their financial planning goals.