Roth IRA Conversions: America’s Hottest Trend, For Good Reasons
Should you do a Roth conversion? There is no easy answer to that question beyond “it depends.” There are potential pitfalls, and there are many things to consider, but in situations where it does make sense, there are few things an investor can do that can have a bigger impact on their personal financial security or their legacy.
Roth conversions can be a powerful tool for retirement security and wealth creation. The law is complex, the timing of conversion matters, and you may have to write one of the biggest checks in your life, but when the math works, magic can happen. Here’s what investors should know:
What is a Roth IRA Conversion?
A Roth conversion is the process of legally transferring funds from a traditional retirement account, such as a Traditional IRA or 401(k), to a Roth IRA. This is the single most important fact you should know: the converted amount is treated as taxable income in the year of the conversion.
So, given that, why convert to a Roth? The benefits of a Roth conversion explain the explosion of its popularity: conversions were up 46% year over year in the second half of 2024, per Fidelity. In short form, here are some of them:
Earnings and withdrawals from a Roth IRA are tax-free, unlike most other qualified plans where withdrawals are treated as ordinary income. Qualified distributions from a Roth are also tax-free. If we stopped here, that would be enough incentive for many people—but that’s not all.
While often overlooked, it’s very important that there are no Required Minimum Distributions from a Roth IRA. This means that your account can compound on its full value right up until its distribution. This can be very significant for your legatees. Another great benefit of Roth IRAs is that beneficiaries can also withdraw funds tax-free.
No Free Lunch
Your Roth conversion will come with some fine print, and you will want to think these things through carefully. First, and most importantly, the amount you convert will be added to your taxable income for the year you make the conversion. Beyond that, this extra income could bump you up to a higher tax bracket.
Given the foregoing, conversions are most advantageous in years when your taxable income is lowest, so planning ahead is a smart idea. Self-employed persons generally have more flexibility in this area than employees. These timing considerations can be crucial to your decision.
It’s best to pay any taxes due to the conversion from non-qualified (after-tax) accounts rather than the retirement account itself, so you can benefit from the tax-free growth of the corpus. Roth conversions generally work better if you have many years before you need to make withdrawals, which will give the account maximum time to compound.
Think Strategically
Conversion works best when it’s carefully planned. It does not need to happen as a lump sum or total account transfer; you can convert an optimal account each year to manage your bracket exposure. You’ll want to stay in your current bracket if possible. In addition, older Americans should give due consideration to their Social Security benefits.
Ideally, you’ll want to do your conversion before you begin to take your Social Security. Eighty-five percent of SSI benefits are taxable as ordinary income, so this matters.
Although this can be incredibly difficult to predict, you may benefit from converting during a market downturn. This is one of those situations where a bear market can benefit you. If your account takes a major hit, you can do the conversion with a lower tax bite, and enjoy the rebound (if there is one) tax-free. Think of this as a form of loss harvesting.
Here’s an idea straight from the family office world: you can help your heirs by timing their income needs with an inherited Roth, which would provide tax-free income for them. This would allow their other accounts to grow and compound, and have the added benefit of remembering who it was who made that happen for them.
Potentially Scary Stuff
Perhaps the worst thing you could do would be to forget that your conversion will create a taxable income event. You must be sure to plan for this and know where the funds will come from to pay your taxes.
The higher income that will accompany a Roth conversion could affect your Medicare Part B and D premiums. This is the sort of detail that many converters overlook and a good reason to get advice from a seasoned pro with expertise in this area. A Roth conversion can make sense for older Americans, but you’d be wise to game the situation carefully before you act.
The power of compounding is hugely dependent upon time. If you may need funds from the converted account within a few years, the upfront tax bill may outweigh the benefits of conversion. Financial planning is largely an exercise in probabilities; you do not want to count on luck as a part of your strategy.
More Good News
Unlike contributions to a Roth IRA, there is no income cap consideration and no limit on the converted amount for a Roth conversion. The IRS would like you to make the conversion so they can collect the income tax due on the effective withdrawal. That one fact should be a caution for you, but your unique circumstances may make the deal a smart one for you.
Of course, there is no free lunch. Note this carefully: any converted funds must stay put in the IRA for at least five years before you can withdraw them tax-free, no matter how old you are. Understand that illiquidity is a cost of this conversion.
Work with a Professional
If it isn’t obvious already, you should consider professional advice before you pull the trigger. Roth conversion can produce wonderful downstream benefits for you and your heirs, and it can also be a big mistake, depending on your situation.
Given the complexities of tax brackets, income projections, and estate planning considerations, consulting with a financial advisor or tax professional can help tailor a Roth conversion strategy to your specific situation. This is not unlike any medical or legal decision, and you would likely benefit from the experience of a qualified professional.
Would you like to explore a detailed Roth conversion strategy based on your unique situation? We can help you with that, and we’d be happy to. We have specialized planning tools that can help you understand if this might be good for you.
