WTH is a Roth IRA conversion and does it make sense for you?

by | Dec 6, 2022

What is a Roth IRA conversion?

A Roth IRA conversion is a strategy to help you save money on taxes (if done correctly) in the long run. A conversion moves pre-tax dollars from your retirement accounts such as a 401(k) or IRA into a Roth IRA. The amount that you convert will be treated like ordinary income, so you will have to pay taxes on the conversion in the tax year that you complete the conversion. Why pay taxes now? For a few reasons. The primary benefits of converting funds into a Roth IRA are that they will provide tax-free income in retirement (so you have your Roth IRA growing for many years and when you take a withdrawal in retirement, no taxes!) and the Roth won’t be subject to RMDs when you reach age 72 (which you have to do with Traditional IRAs/401(k)s). This can be extremely beneficial to help you reduce your tax liability in the future, but there are a few things to consider before deciding to complete a Roth conversion since it can come with a high price and may not be a fit for you. 


Why would I consider doing a Roth IRA conversion this year? 

There are a handful of reasons why completing a Roth conversion may make sense. One, If you expect to be in a higher tax bracket in retirement (due to a higher income or increase in tax rates through legislation) then you may want to consider this strategy as you will pay fewer taxes. Two, you want to maximize your estate for your heirs. Three, your investment accounts aren’t diversified by tax treatment (you have too much money in pre-tax accounts). Four, you have irregular income streams or if you have a lower income year. Five, it may be the only way you can get funds into a Roth account (if you make too much for a Roth contribution or your employer doesn’t offer a Roth 401(k), then this is the only strategy that may work for you). 

As a reminder for a regular Roth contribution in 2022, you are capped at a $6,000 ($7,000 if you are 50+ years old) contribution and you can only contribute up to that max if you are making less than $129,000 ($204,000 if married filing jointly). For the exact income restrictions and allowed contributions, review the tables on IRS.gov. A Roth conversion allows you to contribute more than those limits even if you have an income that would disqualify you from a Roth IRA. 


Who should not consider a Roth conversion?

For some people, a Roth conversion may not make sense. One, if you are nearing retirement and need your traditional IRA to cover your expenses, then this probably isn’t a great fit as you need time to recoup the taxes you pay on the conversion. Two, if you are currently receiving Social Security or Medicare benefits (as a conversion increases your taxable income, then your Social Security benefits would be taxed and potentially cause your Medicare costs to increase). Three, if you don’t have the cash to pay the taxes on the conversion (it generally never makes sense to use Traditional IRA funds to pay the conversion tax). Four, you plan on gifting a substantial amount of your IRA to charity.


What should I be aware of before deciding to do a Roth conversion?

  • You pay ordinary income taxes on the amount that you convert to a Roth IRA. You will want to work closely with a tax expert and financial professional to decide if the cost is worth the investment and be aware if the conversion moves you into a higher tax bracket.
  • Since a Roth conversion will increase your taxable income, you will want to review any programs or benefits you have where eligibility is income-based. If your income is too high because of the Roth conversion, you may lose those benefits. Examples of this could include financial aid, income-based student loan repayment plans, health insurance subsidies, Medicare, etc).
  • A 5-year rule applies to Roth IRA conversion. Usually, you can withdraw Roth IRA funds that you contributed at any time. However, converted funds must stay in the account for 5 years, or else a 10% early withdrawal penalty will apply. If you need to start taking withdrawals in the next 5 years, this may not be a good strategy for you. 


Is there a limit to how much I can convert?

There isn’t really a limit to how much you can convert or how often. However, because there is a tax liability associated with a Roth conversion, you will want to be cautious converting enough to push you into higher tax brackets that could negate the benefits that a Roth conversion offers. The goal is not simply to pay no taxes on income in the future, the goal is to reduce overall lifetime tax liability. You will likely convert a portion of your IRAs over several years or time the conversion for years where income is lower. Heads up that there is no way to undo a Roth conversion. For a detailed analysis of a good Roth conversion strategy, work with a financial planner that can help you project tax liability, investment opportunities, and income needs for retirement. 


If you want to explore in more detail if a Roth conversion is right for you, review the flow chart below, then talk with your financial planner. This strategy must be completed by the end of the year if you want the income to be reported on the current year’s tax return so don’t wait!