Is a Roth Conversion Right for You? Consider These 6 Factors

The Roth conversion is a popular year-end tax maneuver for DIY retirement planners. It works just as well at the start of the year, but more people are interested in December. 

The move involves transferring retirement assets from a traditional IRA, 401(k), or other pre-tax account into a Roth IRA.

Conversions incur a tax consequence in the year of the conversion. But once in a Roth, the money grows tax-free, and withdrawals are tax-free. 

That’s a key distinction. Withdrawals from pre-tax retirement accounts are taxed in retirement. 

Furthermore, Roth IRA money is not subject to required minimum distributions (RMDs) like pre-tax money. RMDs kick in at age 73 (now) or 75 (starting in 2033), forcing us to withdraw money and create a taxable event. 

So, the more money we convert from pre-tax accounts to Roth accounts, the more flexibility we have with long-term planning. And the earlier you can get money into a Roth, the longer it can grow and make up for the upfront tax payment.

Because of the current year’s tax consequences of a Roth conversion, it is best to do them when you’re in a lower tax bracket (e.g., 12%), so they are particularly advantageous when you are between jobs, semi-retired, or unemployed.

It can make sense in higher tax brackets, but the current tax consequence becomes more burdensome and may negate the positive long-term benefits, depending on several variables, including anticipating what future tax rates will be.

So conversion calculators or comprehensive retirement software are essential to inform decisions as long-term financial consequences can reach tens or hundreds of thousands of dollars.

I recently published a demonstration video calculating Roth conversions to share some basics.

6 Roth Conversion Considerations

Here’s what the IRS says about converting from a traditional IRA into a Roth IRA: 

You can withdraw all or part of the assets from a traditional IRA and reinvest them (within 60 days) in a Roth IRA. The amount that you withdraw and timely contribute (convert) to the Roth IRA is called a “conversion contribution.” If properly (and timely) rolled over, the 10% additional tax on early distributions won’t apply. However, a part or all of the distribution from your traditional IRA may be included in gross income and subjected to ordinary income tax.

The conversion within your broker is usually instantaneous, so the 60-day requirement is moot. But there is a five-year waiting period to access the funds without penalty.

When you do a Roth conversion, you receive a form 1099-R in the mail from your broker during tax season, and you need to include the amount on Form 8606 with your tax return. I converted $15,000 in 2023, and my tax software handled it easily.

After leaving my full-time career in late 2022 and benefiting from business tax deductions, my income was low enough to allow me to convert some money. And I could have done more, but I was a bit cautious. 

I plan to do several more over the coming years when the numbers are favorable. 

Here are six considerations if you are considering doing a Roth conversion this year or next.  

1. Current vs. Future Tax Rates

This is the most important and frustrating factor to consider for Roth conversions.

The primary premise of a Roth conversion is based on paying lower taxes today than in the future.

To precisely calculate that benefit, we need today’s tax rates — which we know — and tomorrow’s tax rates — which we don’t know. 

Unfortunately, many online calculators ask you to guess what you think future tax rates will be. This is a fool’s errand if looking out more than five or ten years from now. 

So, we have to work entirely with today’s rates and adjust when rates change. 

I’ve read multiple analysts saying things like “tax rates must go up in the future to pay for the national debt”. 

This ignores that half of federal elected officials have signed a pledge never to raise taxes, and the other half write their political obituary if they vote for severe individual tax increases.

But we can assume that a tiered tax bracket of some form will likely persist due to pragmatism, and the lower tax brackets today will not become the high tax brackets in 20+ years. 

Added to the substantial benefits of having money in a Roth vs. pre-tax account, we can safely assume converting at the lowest tax brackets (10% and 12%) is a good deal while converting at the highest brackets (32%, 35%, and 37%) is a bad deal.

Many of us fall in the middle range of 22% and 24%, requiring calculation, assessment, and judgment calls. 

2. Age and Time Horizon

I did my first Roth conversion at age 48. RMDs won’t kick in for me until I’m 75, giving the $15,000 I converted 27 years to grow tax-free. At a 7% rate of return, it will be worth about $93,000.

That money would be worth the same in a traditional IRA, but I’d be required to start withdrawing some of it at 75 and pay taxes. In a Roth, neither is necessary. 

So age plays a role because the longer the time horizon, the greater the asset growth and tax impact.

That said, retirees often hit a sweet spot between ages 60 and 73, when they are done earning active income but haven’t yet reached RMD age.

A lower retirement income can lead to a lower current tax rate for conversions and somewhat more predictable future tax rates the closer you are to the RMDs.  

They benefit from tax-free growth and withdrawals and more flexibility in retirement and estate planning.

Additionally, the time horizon influences the potential to recover the upfront tax cost of a conversion. Expected longevity plays a role as well.

For investors close to retirement, careful planning is needed to balance the tax impact to minimize required minimum distributions (RMDs).

Consider your age and timeline alongside your broader long-term financial goals to ensure Roth conversions align with your retirement strategy.

3. Available Funds for Tax Consequences

Current year Roth conversions require paying extra taxes when filing a return. A refund may cover modest conversions. 

But as the conversion amount and tax increase, we may need to pony up some cash out-of-pocket or sell taxable holdings to cover the costs. 

Ideally, we have the cash on hand.

We can also convert additional funds (enough to cover the tax) and withdraw non-converted Roth funds to pay the taxes. But this defeats the purpose of a Roth conversion (getting money into a Roth) and is not recommended. 

4. Premium Tax Credit (PTC) and IRMA

Roth conversions can impact Premium Tax Credit (PTC) eligibility for those on an ACA marketplace healthcare plan.

The taxable income generated from a conversion might push the Modified Adjusted Gross Income (MAGI) above the threshold for receiving this credit, potentially increasing health insurance premiums (or reducing the tax credit).

A Roth conversion will take you close to the limits for PTC eligibility and should be scrutinized if you rely on rebates for your annual cash flow. On the other hand, modest conversions over several years may have a limited impact on PTC, but they can still be worthwhile. 

Similarly, high-income Medicare beneficiaries must consider the impact on Income-Related Monthly Adjustment Amounts (IRMA).

Roth conversions increase the MAGI, which can trigger higher Medicare Part B and Part D premiums (see IRMA tax tables).

IRMA is based on income reported two years prior, so a conversion today could affect premiums for future years.

Precise calculations become even more important to minimize these costs while achieving your long-term financial goals.

DIY planning tools and calculators can inform decisions if you’re balancing the benefits of a Roth conversion with concerns about PTC or IRMA. As the dollar amounts increase, asking a tax professional may be prudent to navigate the complexities and avoid costly mistakes.

I’m nowhere near this consideration, but I’ve interacted with several retirees online who consider this a primary concern. 

5. State Taxes

The amount converted from a traditional IRA to a Roth IRA is typically added to your taxable income for the year, and states that tax income generally includes this in their calculations.

For those living in states with a high-income tax rate, the upfront tax cost of a Roth conversion can be significant, making careful planning essential.

If you live in a state with no income tax or that does not tax IRA withdrawals, there is no state tax impact for a Roth conversion. Therefore, if you’re planning to move to one of these states, waiting for the move can help alleviate the burden. Converting in a relocation year could also trigger double taxation, so understand the rules.

Like all financial maneuvers, consider state taxes as part of a broader tax and planning strategy, ensuring that the long-term benefits of the Roth account outweigh the upfront state tax costs.

6. Estate Planning Benefits

Assets in Roth accounts are typically saved until all taxable and pre-tax retirement accounts are exhausted from a withdrawal strategy because of RMDs for pre-tax accounts and tax-free withdrawals of Roth accounts.

Since this money is often tapped last, it becomes the inheritance portion of your estate if you pass before outspending your wealth. It also has the potential to grow to a larger sum. 

Non-spouse beneficiaries of inherited traditional and Roth IRAs must withdraw the total amount of the inherited retirement account within ten years. 

However, inherited Roth IRAs are generally better than traditional IRAs because withdrawals are tax-free for heirs as they are for the original owner.

By converting to a Roth, you ultimately cover your heirs’ taxes. And in tax-free states, this can be extra beneficial to heirs who live in high-tax states. Fidelity has a good article on this topic. 

It also makes tax planning more predictable for the heir, who will not have to contend with RMDs on the inherited amount or exceeding income tax thresholds.

Roth Conversion Tax Calculator (Video)

Late in 2023, my Fidelity Roth IRA Conversion video became a helpful example for others in the same position. 

This year, I’ve gone deeper into the topic, showing the Roth conversion tax calculator I used to determine how much to convert and highlighting Boldin’s capabilities to visualize the effects of this powerful financial maneuver. 

Watch the 22-minute video below or on YouTube. 

Featured image via Deposit Photos used under license.