What is a Roth conversion?

A Roth conversion allows a traditional IRA owner to transfer assets from their traditional IRA to their Roth IRA. Because Roth IRAs must be funded with after-tax dollars, the entire amount of the conversion will be added to the owner’s taxable income in the year of the conversion. At the most basic level, Roth conversions are effective at reducing taxes over your lifetime when you can convert assets at a lower tax rate than you would face if you simply withdrew assets as needed (or required through required minimum distributions) from a traditional IRA.

Remember that there are significant differences between Roth accounts and pre-tax “traditional” accounts. Whether or not these differences are advantageous to you depends entirely on the specifics of your personal situation. The rules governing income taxation and tax penalties for retirement accounts are very complicated, and we strongly recommend seeking the advice of a CERTIFIED FINANCIAL PLANNER™ and/or CPA prior to making contribution, withdrawal, or conversion decisions. That being said, the biggest benefits of doing a Roth conversion are as follows:

• Distributions from Roth IRAs where the contributions or converted assets have been held for more than five years and the original owner has either reached age 59 ½, died, or become disabled are always tax and penalty-free.

  
  

• After a five-year holding period, withdrawals up to the amount of the conversion can be made income tax and penalty-free, regardless of age. If you are over 59.5, the five-year holding period to withdraw the conversion amount does not apply.

  
  

• There are many other situations in which tax and penalty may be avoided.

  
  

• Roth IRAs never have RMDs. This is a major benefit for those fortunate enough to not need distributions from retirement accounts for living expenses. This benefit extends to spousal Roth IRA beneficiaries. Do keep in mind that non-spousal beneficiaries typically need to withdraw the full value of inherited Roth IRAs within 10 years of the date of death of the original account holder.

What factors make Roth conversions more effective?

Roth conversions are typically the most effective when you can convert a large percentage of your pre-tax (traditional) assets at a low tax rate. We often find that conversions offer the most value when clients have several years between their retirement date and the start of Social Security or RMDs. They usually fund living expenses from their taxable brokerage accounts during this period, resulting in lower income and a lower effective tax rate. This isn’t the only period when someone might have a reduced level of income- just the most common.

Along the same lines, the younger a person is and the more years they have to do conversions at low rates, the more beneficial the strategy becomes. By spreading out the conversions over many years, younger folks are often able to convert more total pre-tax assets at a low tax rate. Furthermore, being younger means more years before Medicare (and any IRMAA surcharges) and RMDs.

A downturn in the stock market can also help you convert a larger percentage of traditional assets given the same dollar amount (and therefore taxable income) of conversion. Large market corrections are often associated with recessions, and some people see incomes fall during these periods as well, reducing their marginal tax rate. This is a strategy that can be used opportunistically during downturns- assuming you have cash available to pay the tax.

Changes in the tax code can also be used opportunistically. Legislative tax provisions often “sunset” by a certain date. A good example is the 2017 Tax Cuts and Jobs Act, which was scheduled to sunset at the end of 2025 until Congress made the changes permanent through the One Big Beautiful Bill Act. A timelier example would be the expanded standard deduction for those age 65 or older with incomes below the thresholds; this provision will only be in place from tax years 2025 – 2028 as currently legislated.

Paying attention to current tax rates relative to history and the size of the federal debt can provide guidance on the effectiveness of Roth conversions. We are currently in a very low tax regime, and the federal debt is very high. This is a good indication that tax rates are likely to be higher in the future than they are now, increasing the probability that a Roth conversion today will work in your favor.

If your financial plan includes a goal that requires a large IRA distribution in the future, Roth conversions could help blunt the tax hit by spreading the taxes over several years and allowing tax-free growth in the Roth IRA. However, careful planning must be done to ensure compliance with Roth IRA distribution rules.

If you plan to leave an IRA to an heir in a high tax bracket, Roth conversions can become more valuable. Take the example of a recently retired 60-year-old who plans to leave their traditional IRA to their 30-year-old child- the parent is likely already in a lower tax bracket than the child, and when the child inherits the IRA, the child will very likely be near their peak earning years and in a higher tax regime. Roth conversions by the parent are therefore a strong estate planning tool.

What factors make Roth conversions less effective?

At the most basic level, the smaller your traditional IRA is, the less effective a conversion will be. This is simply a factor of there being less potential future income, and therefore less tax to attempt to reduce.
Roth conversions tend to be less effective when you are currently in a relatively high tax bracket. There are many sources of income that are often overlooked in retirement and that affect the feasibility of Roth conversions, such as pensions, annuities, Social Security, and portfolio income from taxable brokerage accounts.

Many people retire around the same time they lose a parent and inherit a traditional IRA. This typically increases their income. Under the current rules for non-spousal beneficiaries, this inherited IRA would be subject to RMDs if the decedent had reached their required beginning date, and the entire value would need to be withdrawn within 10 years. Depending on the size of the inherited account, these withdrawals (which are added to taxable income) could push you into a high enough tax bracket to reconsider Roth conversions.

We typically recommend clients pay the taxes on Roth conversions from their taxable account. This is because assets in a taxable account have a lower after-tax average return than assets in a Roth IRA (which are subject to neither capital gains nor portfolio income taxation). Furthermore, if taxes are withheld from the conversion amount and you’re under age 59 ½, under certain circumstances the tax withholding amount can be considered a distribution, which would be subject to the 10% early withdrawal penalty. Not having enough assets in taxable accounts can make conversions less effective.

Another factor that comes into play is simply an unwillingness to break into higher tax or Medicare IRMAA brackets. This is a matter of personal preference, but it can’t be ignored. In many cases, an effective long-term Roth conversion strategy may require going up a tax bracket or two. Medicare IRMAA surcharges are based on income, and they can ramp up quickly. These surcharges can be as high as nearly $700 per person per month, and understandably, many people don’t want to pay these higher rates.

We’ve analyzed many conversion scenarios for clients over the years, and in most cases, it takes years before the client breaks even (or comes out ahead) on the strategy. Therefore, if you don’t have a family history of longevity or have health issues yourself, conversions are less likely to be beneficial.

In Conclusion

This blog just scratches the surface of everything we consider when planning Roth conversions for clients. We always recommend working with both a CERTIFIED FINANCIAL PLANNER™ for longer-range planning and a CPA for year-by-year planning for Roth conversions. There are many rules associated with IRAs, and this should not be considered to be an exhaustive resource on the subject. As a reminder, the IRS no longer allows taxpayers to recharacterize a conversion after the fact, so consider all factors carefully before you act.

If you or someone you know would like to explore Roth conversions, don’t hesitate to reach out to us!