A Roth conversion can offer significant benefits, but it comes with important tax implications.
Benefits
Contributions to Roth IRAs have already been taxed, which means you’ll have tax-free withdrawals of contributions and earnings in retirement (after age 59½ and if the account has been open for at least 5 years). This can be a major advantage if you expect to be in a higher tax bracket during retirement or if tax rates rise in the future.
Unlike traditional IRAs and 401(k)s, Roth IRAs are not subject to RMDs during the account holder’s lifetime. This allows you to keep your savings invested for longer, potentially growing tax-free, or to pass more wealth to heirs.
Roth IRAs can be passed to heirs, who can generally withdraw funds tax-free (though they may need to take distributions within a certain period, typically 10 years under current rules). This can make Roth IRAs an attractive option for legacy planning.
Roth IRAs also allow you to withdraw your contributions (not earnings) at any time without penalty or taxes. While this isn’t ideal for retirement savings, it provides more flexibility compared to traditional accounts.
Tax Implications
When you convert funds from a traditional retirement account to a Roth IRA, the amount converted is treated as taxable income in the year of the conversion. For example, if you convert $50,000, that amount is added to your taxable income for the year, potentially pushing you into a higher tax bracket.
You’ll owe income taxes on the entire converted amount (including both contributions and earnings) at your marginal tax rate, unless some of the traditional account contributions were non-deductible.
A large conversion could push you into a higher federal or state tax bracket, increasing your overall tax bill. This makes it critical to plan the conversion amount carefully, possibly spreading conversions over multiple years to stay in a lower bracket.
Strategic Considerations
Converting in a low-income year (e.g., after job loss, early retirement, or a business loss) can minimize the tax impact, as you’re more likely to be in a lower tax bracket. Partial conversions over several years can help manage tax liability and avoid spiking into a higher bracket.
The longer you have until retirement, the more time the Roth IRA has to grow tax-free, offsetting the upfront tax cost. Younger individuals or those with decades until retirement may benefit more from conversions.
Converted amounts are subject to a five-year holding period for penalty-free withdrawals of earnings (if under 59½). Each conversion has its own five-year clock, which can complicate planning if you convert in multiple years.
Roth conversions are complex and depend on your unique financial situation, tax bracket, state laws, and retirement goals. A Federal Retirement Consultant (FRC®) can help you decide if a Roth conversion is right for you.
