What Is a Roth Conversion?

In our Monthly Financial Jargon series, with the end of the year drawing closer, we are diving into a term that is a potentially valuable tax-saving strategy you may want to consider taking advantage of before year-end: Roth Conversion.

What is a Roth Conversion?

A Roth Conversion relates to individual retirement accounts (IRAs), and this strategy involves converting from a traditional IRA to a Roth IRA. As a reminder, an IRA is separate from an employer-sponsored retirement plan – like a 401(k) or a 403(b) – and this type of account allows you to save for your retirement in addition to your employer-sponsored plan if you have one. IRAs bring potential tax savings if you understand the benefits of the different tax incentives the two main types of IRAs – Traditional and Roth – offer.

Traditional IRA vs. Roth IRA

To understand what a Roth Conversion is and why you may want to consider leveraging one if you are able to, it is important to comprehend the differences between a Traditional and a Roth IRA.

• A Traditional IRA allows you to contribute pre-tax dollars. Your money therefore grows tax-deferred, and withdrawals are taxed as income according to your tax bracket upon the withdrawals after age 59 ½. That being said, a Traditional IRA gives you immediate tax benefits. Anyone with earned income is eligible to contribute to a Traditional IRA. Traditional IRAs require you to take required minimum distributions (RMDs) after age 72, and these distributions count as taxable income in retirement.
• A Roth IRA allows you to contribute after-tax dollars, meaning your money grows tax-free. Therefore, you can make tax-free withdrawals after age 59 ½. A Roth IRA provides you with no immediate tax benefits. Eligibility is based on your income level; only individuals with income below a certain level are eligible to open and fund a Roth IRA. Roth IRAs are not subject to required minimum distributions (RMDs) in the future.

Both Traditional and Roth IRAs are beneficial accounts to consider when it comes to supplementing your retirement savings outside of your employer-sponsored retirement plan. First and foremost, you need to determine if you qualify for a Roth IRA. For 2024, individual tax filers must have a Modified Adjusted Gross Income (MAGI) under $146,000 to contribute to a Roth IRA; if you are married and filing taxes jointly for 2024, your MAGI must be between $230,000 and $240,000. Keep in mind that the maximum total annual contributions for all IRAs combined is $7,000 if you are under age 50 and $8,000 ($7,000 plus a $1,000 catch-up contribution) if you are age 50 and older.

A Traditional IRA tends to be best suited for someone who anticipates being in an equal or lower tax bracket in the future when he or she begins taking withdrawals from the account, while a Roth IRA is typically best suited for an individual who expects to be in a higher tax bracket when he or she starts taking withdrawals. Put simply, the decision between which type of IRA is optimal for your financial life depends on which type of account will allow you to optimize your tax savings. A prudent question to analyze: will saving on taxes now benefit you most or will saving on taxes in the future bring you the most savings?

Why Consider a Roth Conversion?

Fundamentally, if you are eligible to do so, converting a Roth IRA can save you money in retirement if it makes financial sense for you to pay taxes on retirement savings now as opposed to in the future. Remember how we discussed income limits for contributing to a Roth IRA? Well, there is a workaround to those restrictions, and this strategy is known as a Roth Conversion. A Roth Conversion allows you to convert existing traditional IRA funds to a Roth IRA, regardless of income level. Here are a few important conditions to consider:

• If your annual income stream fluctuates, and you have a lower than usual income this year, you should consider doing a Roth conversion. This could allow you to convert funds to a Roth IRA with minimal tax impact since you would be in a lower tax bracket for the year based on your lower income level.
• If you foresee your tax bracket being higher in retirement, then paying taxes at your current presumably lower tax rate is preferable. Although paying higher taxes in retirement may sound unlikely, it is very possible if you have not yet reached your peak earning years and/or if you have accumulated significant funds in your retirement accounts that will lead to high required minimum distributions (RMDs) that will count towards your taxable income.
• If you lack tax diversification in your current account types and all of your current accounts are tax-deferred, it may be wise to do a Roth Conversion so that you have some assets that will be tax-free upon withdrawal in the future.
• If you are nearing or in retirement, you may realize that converting your Traditional IRA savings to Roth savings may bring too large of a tax burden at once since you are presumably needing to begin tapping into these funds in the near future.

Converting to a Roth IRA

If and when you conclude that a Roth Conversion is beneficial to your financial life and you want to move forward with the strategy, there are several important items to keep in mind.

• Paying the tax bill: When you complete a Roth Conversion, you pay taxes on all of the funds you are converting, which could mean a sizable tax bill. The funds you convert are taxed as ordinary income. Make sure you are aware what this amount is and consider using cash outside of your Traditional IRA so that you are not taking funds from your retirement savings.
• Timing the conversion and determining how much: Depending on the amount you are looking to convert, it may be wise to devise a systematic Roth Conversion plan that involves spreading your overall targeted conversion amount out over several years to limit your tax impact if executing a large conversion pushes you into a higher tax bracket for a given year. You do not want to convert all of your desired tax-deferred savings at once and suffer an unnecessarily – and avoidable – hefty tax bill.
• Beware of the Five-Year Rule: If you contribute funds directly to a Roth IRA, you are allowed to withdraw your regular contributions tax- and penalty-free at any time and at any age (note: this applies to contributions, not earnings). However, funds converted into a Roth IRA must remain in your Roth IRA for a minimum of five years to avoid a 10% early withdrawal penalty.
• Roth Conversions are irreversible: Once completed, you cannot undo a Roth Conversion! Ensure you are confident in your conversion strategy and how it complements your financial planning now and in the future.

For now, there are no basically no limits on how many Roth Conversions you can make from a Traditional IRA and no restrictions on the amounts of your conversions. Keep in mind that the deadline to make a Roth Conversion for the current year is December 31.

Final Points

Which type of IRA is right for you depends on your specific retirement goals, current tax bracket and projected future tax bracket, among other aspects of your financial life. To make a well-educated decision, you need to decide if it makes more financial sense for you to enjoy tax-free withdrawals in the future via a Roth IRA or if it is more financially prudent for you to take immediate advantage of tax benefits through a Traditional IRA. Remember, when executing a Roth Conversion, you can convert all or simply a portion of funds in your Traditional IRA to a Roth IRA – it is not an all-or-nothing strategy, and it may be prudent for you to do a certain amount and not your whole account. Consult with your financial advisor about whether or not a Roth Conversion would be a valuable strategy to leverage in your financial life.

Monthly Financial Jargon: The world of finance and investments is notorious for its extensive use of jargon. With a goal to enhance financial literacy and make the world of money more transparent, we have our “monthly jargon” articles that focus on debunking financial terms that are often used sans explanation.

Questions and/or interested in how this applies to your financial life?

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