Roth Conversions: How They Work and When You Should Use Them

What is a ROTH Conversion?

A ROTH conversion is a simple way to change your traditional IRA funds into Roth IRA funds.¹ The utility of this action, of course, is that Traditional IRA funds are pre-tax, meaning you have yet to pay taxes on them, while ROTH IRA funds are after-tax, meaning you’ve already paid the taxes on them and they can grow tax-free for “forever”. ROTH conversions are not right for everyone but, in the right context, can be a great way to supercharge your retirement savings, if you think your tax rate will be higher when you retire.¹ Keep on reading to learn how ROTH conversions work and when to use them!

What Actually Happens During a ROTH Conversion

You convert your traditional IRA into a ROTH IRA. This means that you will pay taxes on the money in the account now, but all future withdrawals are tax-free.

Once you declare the conversion, you’ll get a check or some form of distribution from your IRA. At that point, you’ll have up to 60 days to reinvest the funds from the conversion into a new Roth IRA.⁴ If you don’t reinvest the money, it will be taxed as ordinary income so it’s important to make sure you’re ready to “house” the funds in a new ROTH IRA and no hiccups can delay the process.¹

You may be wondering “I’m a high earner, am I disqualified from ROTH conversions?”. Thankfully, there are no income limits for converting to a Roth IRA, so anyone can do it.⁴ However, there are some things to consider before you convert that are covered in the paragraphs below.

Converting to a Roth IRA can be a great way to save more efficiently for retirement, but it’s not right for everyone. As always, be sure to talk with a financial advisor and/or tax professional to see whether it’s right for you.

When Do You Use a Roth conversion?

A Roth conversion can be a great tool for saving on taxes, but it’s not right for everyone. Here are several scenarios where a ROTH conversion makes sense.

If you’re in a high tax bracket: A Roth conversion can be a good way to save on taxes if you’re in a high tax bracket. By converting your traditional IRA to a Roth IRA, you’ll pay taxes on the money you convert at your current tax rate. That means that if your tax rate goes up in the future, you’ll still have saved on taxes by doing the conversion.²

If you think your tax rate will go up in retirement: Another reason to consider a Roth conversion is if you think your tax rate will go up in retirement. Because you’ll pay taxes on the money you convert at your current tax rate, this can be a good way to get a lower tax bill in retirement.²

If you have a large traditional IRA: If you have a large traditional IRA, converting it to a Roth IRA can help you avoid some of the downsides of having a traditional IRA, such as required minimum distributions. With a Roth IRA, there are no required minimum distributions, so you can let your money grow without having to take any out.¹

In lower income years. It is often a good strategy to do a roth conversion the immediate year after you retire because your income tax rate will be much lower without your employment income. It’s also a good strategy to do a roth conversion in a down market year when your assets are trading at a discount so you basically get the roth conversion tax bill on sale.

If you have a traditional IRA that is invested in assets that are subject to high levels of taxation (such as mutual funds or real estate): These assets are likely the highest growing in your portfolio and, therefore, converting to a Roth IRA can help you save on taxes in the long run by putting your highest growth/taxed investments in one of your best tax locations.³

Is a ROTH Conversion Right for You?

If one or more of the previous scenarios resonated with you, it’s likely a ROTH conversion would help you harness your retirement assets more effectively. There are some things to consider before you do a Roth conversion, however.

First, you’ll have to pay taxes on the conversion amount. If you convert $50,000 from a traditional IRA to a Roth IRA, you’ll owe taxes on that $50,000.

Second, you need to make sure you have enough money outside of your retirement accounts to pay the taxes on the conversion. If you don’t, you may end up having to take money out of your Roth IRA later (which would defeat the purpose).¹

Finally, there’s no going back once you do a Roth conversion. So, make sure you’re absolutely certain it’s the right move for you before you do it. Run the numbers and make the best decision for your unique situation.

Clarification

There is a difference between the Roth conversion and the backdoor Roth IRA. These are two completely different strategies and both may be advisable for your situation. While there is a limit on how much you can backdoor Roth IRA ($6,000 per year, or $7,000 per year if you’re age 50 or older), there is no limit for how much you can convert in a Roth conversion. Another option would be the Roth 401(k) which has recently been referred to by financial advisors as the “Mega-Roth” because you can put so much more into it when it is sponsored by your employer. This can be very advantageous if you own your own business.

Conclusion

There are many factors to consider, but ultimately a Roth conversion can be an excellent way to diversify your tax liability and save for retirement.⁴

If you are considering a Roth conversion, make sure to do your homework. We always recommend speaking with a financial advisor and/or tax professional to investigate whether it makes sense for your unique situation. If you’d like to speak with one of our advisors on this matter, fill out the contact form on this site! We’d love to help walk you through this complicated topic.

Thanks for reading! We hope this article has helped you better understand how Roth conversions work and when you should use them.

Sources

1: https://www.investopedia.com/terms/i/iraconversion.asp

2: https://www.yahoo.com/entertainment/roth-conversions-play-key-role-084205163.html

3: https://www.cnbc.com/2022/07/29/roth-ira-conversion-timing-is-perfect-for-young-investors-says-cpa.html

4: https://www.wellsfargo.com/investing/retirement/ira/roth-ira-conversion/