Roth Conversions Made Simple

Roth conversions are a hot topic in the world of finance. In this article, I’ll break down what they are, who they may (or may not) make sense for, and how to approach them in your financial planning.

It’s important to first understand the basics of Roth IRAs, so if you haven’t, I suggest reading this article first.

Executive Summary

• Roth conversions let you pay taxes now in exchange for tax-free withdrawals later.

• They work best when your current tax rates are lower than what you expect in the future.

• Conversions require careful timing and planning to avoid unnecessary costs.

Why Roth Conversions Matter

No one can predict future tax rates, legislation, or personal financial circumstances with certainty. What works today may change tomorrow. That’s why it’s important to treat Roth conversions as a tool - not an end-all strategy. Think of it as an optimization technique; Roth conversions should never make or break your retirement or financial plan.

Think of it this way: You’re simply using the tax rules we know today to hedge against an uncertain future. Many view Roth conversions as a form of tax insurance.

Understanding Pre-Tax vs. Roth Accounts

Let’s break down how each account works, starting with pre-tax accounts. You get a tax deduction today when you contribute funds; the funds can then grow tax-deferred, and in the future, when you withdraw, you will pay taxes on your contributions and earnings (typically used if you think your future tax rates will be lower)

Pre-tax accounts also have Required Minimum Distributions (RMDs) starting at age 73 or 75 (depending on birth year), where the IRS forces withdrawals from pre-tax accounts. These withdrawals are taxed as ordinary income and may exceed your actual spending needs. The withdrawal amount is based on a calculation involving your account balance and life expectancy.

Additionally, when it comes to inheritances with pre-tax accounts, non-spousal heirs must empty the account within 10 years, sometimes during their peak earning years - creating large, unexpected tax bills.

With Roth accounts, you pay taxes upfront; funds are added on an after-tax basis, can grow tax-free, and withdrawals in the future are tax-free (typically used if you think your future tax rates will be higher). Unlike pre-tax accounts, Roth IRAs are not subject to RMDs, and non-spousal heirs typically inherit the account tax-free.

How Roth Conversions Work

A Roth conversion is when you move money from a pre-tax account (think Traditional IRA, 401(k), 403(b), TSP, etc.) into a Roth IRA. You pay taxes on the amount you convert in any given year.

By converting, you choose to pay the tax bill now so that future growth and withdrawals can be tax-free (provided you meet the requirements for qualified distributions in your Roth IRA). You are using the knowns of today in the tax world to protect yourself from the unknowns of tomorrow.

The underlying reason for this is simple: you believe your tax rates today are lower than they will be in the future, and you would rather pay the tax now than later.

When a Roth Conversion Can Help

There are times when a Roth conversion may make sense. It may involve one or more of these factors, but that does not mean you should or shouldn’t do it - it just highlights situations where it could potentially make sense:

1. You expect to be in a higher tax bracket later (e.g., currently 12%, but expect 32% in retirement).

2. You want to leave tax-free assets to heirs.

3. You are married now, but may be single in the future (single tax brackets are more compressed, and deductions are generally lower).

4. You plan to move to a higher-tax state.

5. You have large pre-tax balances that would trigger large RMDs you may not need (size is subjective).

6. You want tax flexibility - having both pre-tax and Roth accounts creates “tax diversification” in retirement

When a Roth Conversion Might Not Help

1. You believe your future tax liability will be smaller (e.g., currently 32%, but expect 12% in retirement).

2. You are charitably inclined and plan to give pre-tax assets to charity through Qualified Charitable Distributions (QCDs).

3. Your RMD aligns with your income needs. Conversions may not add value if this is the case.

4. You don’t have cash available to pay the tax bill. Converting without cash on hand may not make sense.

The Right Timing for Conversions

With either type of retirement account, withdrawals must be qualified - meaning you must have reached the appropriate age (usually 59½) to avoid early withdrawal penalties or additional taxes.

With Roth accounts, you can withdraw contributions at any time. However, to withdraw earnings, they must be qualified, which means you must satisfy these two rules:

• The account must have been open for at least 5 years, and

• You must be 59½ or older

There are a few exceptions covered in our previous article (such as buying your first home or covering certain emergency expenses). For conversions, each conversion has its own 5-year waiting period, and you must also be 59½. This makes timing crucial.

Timing is key. Ideally, you convert when your income is low and/or the market is down, allowing you to convert more shares at a lower tax cost. Each conversion has a 5-year waiting period; careful timing ensures you can meet your retirement needs. These windows often occur in early retirement years, before Social Security, pensions, and RMDs begin. Other situations - such as job loss, reduced pay, or a down business year - may also present opportunities for conversions.

Determining How Much to Convert

There are no hard rules, but you generally want to monitor your marginal tax brackets. In our tax system, as your income rises, you pay higher rates - but not on all of your income.

There’s no one-size-fits-all answer, but the goal is usually to “fill up” lower tax brackets without spilling into higher ones. For example:

• If you expect to face the 32% bracket later, consider converting up to the top of the 24% or 32% bracket now.

• Careful planning helps avoid pushing income into thresholds that trigger other taxes or higher Medicare premiums.

Potential Pitfalls to Watch

Roth conversions can sometimes trigger additional costs or taxes - similar to what may happen with future RMDs. Depending on the size of your conversion, potential side effects include:

• Higher Medicare premiums (IRMAA)

• Net Investment Income Tax (NIIT)

• Loss of Affordable Care Act subsidies

• Increased taxation of Social Security or higher capital gains rates

Practical Tips for Conversions

• It’s best to have cash on hand to pay the taxes rather than using the converted funds. Otherwise, you reduce the value of the conversion and may face penalties if you’re under age 59½.

• Depending on the size of your conversion, you may need to adjust your withholdings or make estimated tax payments to avoid IRS underpayment penalties.

• You cannot convert RMDs. You must take your RMD first before converting any additional funds.

Key Takeaways

• Roth conversions can offer powerful long-term benefits, but they aren’t right for everyone.

• Every conversion is subject to its own 5-year rule.

• Taxes, Medicare premiums, Social Security, and other moving parts must be considered.

• The real value comes not just from knowing the rules - but from applying them strategically to your unique situation.