Roth Conversions Explained: Paying Taxes Now for More Flexibility Later

By Andrew Joski, NSSA®, Founder of Joski Financial

“Should I convert some of my traditional IRA to a Roth IRA?”

It is a common retirement planning question, and the answer depends on more than whether you think tax rates will rise. A Roth conversion can give you more flexibility later, but it creates a tax bill today. The useful question is: Would paying that tax now improve your overall retirement plan?

What is a Roth conversion?

A Roth conversion moves money from a traditional IRA or eligible pretax retirement account into a Roth IRA. The amount that has not previously been taxed is generally included in your income for the year of the conversion. The money can then grow in the Roth IRA, and future withdrawals may be tax-free if they meet the rules for qualified distributions.

For example, suppose you convert $40,000 from a traditional IRA. If that entire amount is pretax, it generally adds $40,000 to your taxable income for that year. You have changed when you pay tax on that money; whether the change benefits you depends on what it costs now and what it may save later.

You do not have to convert an entire account. A series of smaller conversions over several years may be worth considering.

Why would someone do it?

A lower-income year may offer an opportunity. The years after work ends but before required minimum distributions begin can be a useful time to evaluate conversions. Your income may be lower than it was while working, giving you room to convert some money at a tax rate you find acceptable.

Roth money can provide options in retirement. Having both pretax and Roth accounts gives you more choices about where to take withdrawals in a given year. Qualified Roth IRA withdrawals are generally tax-free, which may help you manage taxable income when large expenses arise.

It may reduce future required distributions. Converting some pretax money reduces the balance left in accounts that may be subject to required minimum distributions. Roth IRA owners are not required to take distributions from their Roth IRAs during their lifetimes.

These are potential benefits, not reasons to convert automatically. The tax cost has to make sense in your specific plan.

What could make a conversion costly?

A conversion may push part of your income into a higher tax bracket. It can also cause more of your Social Security benefits to become taxable, affect eligibility for income-based health insurance subsidies before Medicare, or increase Medicare Part B and Part D premiums through IRMAA. Medicare’s income adjustment generally uses tax information from two years earlier.

The source of the tax payment matters, too. If you can pay the conversion tax from money outside the IRA, more of the converted amount can remain invested in the Roth. Paying it from the retirement account reduces what makes it into the Roth and may have additional consequences if you are under age 59½.

Two rules deserve particular attention: an amount that is a required minimum distribution cannot be converted, and a completed Roth conversion generally cannot be undone by recharacterizing it. Roth IRA withdrawals also have qualification and five-year rules that should be reviewed before assuming all money is immediately available tax-free.

How do you decide how much to convert?

Start with a projection, not a round number. Estimate your income and deductions for this year, then compare several conversion amounts. Look at the resulting federal and state taxes, Social Security taxation, health coverage costs, and Medicare premiums where applicable. Finally, compare the tax paid today with the potential effect on future withdrawals and distributions.

Sometimes the right amount is zero. Sometimes a modest annual conversion makes more sense than one large transaction. And sometimes a larger conversion is reasonable because a particular year presents an unusual opportunity.

A Roth conversion is a tool for shaping when you pay taxes and how much flexibility you have later. At Joski Financial, we can help you run the numbers in the context of your retirement income plan, then coordinate the decision with your tax professional before you act.

This article is for general educational purposes and is not individualized tax advice. Tax rules and outcomes depend on your circumstances.