To Convert or Not: When do Roth Conversions Make Sense?

Beginning in 1998, the tax code allowed for a new type of retirement account called a Roth IRA. Senator Henry Roth proposed a new type of retirement account that would allow a taxpayer to pay income tax before making a retirement plan contribution, and in return the account could not only grow tax free (both contributions and earnings), but distributions would be tax-free if certain requirements were met.

So far, so good. Why wouldn’t everyone select a Roth? 

Prior to 1998, all retirement plan contributions were pre-tax. Pre-tax retirement accounts have the benefit of lowering one’s taxable income in the year of the contribution, and those accounts grow tax deferred, BUT income tax is due when distributions are made. This is generally seen as a good choice for many retirement savers, particularly for high earners, who may anticipate being in a lower tax bracket during retirement, when the distribution withdrawals are made. See progressive tax structure on the IRS website here2024 Tax Brackets

However, because the US Treasury Department wants its tax money today, Roth IRA contributions are capped at certain income levels, meaning if you make above the annual threshold Roth IRA contributions are not allowed. Even still, the IRS does allow individuals with pre-tax retirement accounts the ability to do “Roth conversions,” transforming pre-tax contributions to post tax contributions in a Roth account, with all the subsequent advantages. However, converting pre-tax accounts to a Roth type account requires paying income tax on the conversion amount, at the appropriate marginal income tax rate of the year converted. This incremental and elective tax bill can be substantial and is viewed as a major barrier to Roth conversion.

So, when does it make sense to do a Roth conversion?

The decision to convert or not convert is really a matter of math and some planning assumptions. Is it better to save tax now, or save tax later? One may be able to project or estimate when the greatest tax savings will occur. There are financial advisors, online calculators, and any number of forums dedicated to this one specific, but potentially immensely valuable question.

Here are some key considerations:

1. What is my current tax bracket? As noted above, if you are in a higher tax bracket you may wish to stick with the pre-tax account as you will pay tax at your current rate to convert. If you are in a lower tax bracket; it may make sense to convert. This can happen due to unemployment, retirement, or intentionally reducing your income. Of course, you may still be in a higher tax bracket at retirement depending on a number of factors, including how much you have saved in your Traditional IRA!
2. How much has been saved in pre-tax accounts? As a general rule, the larger the pre-tax account(s) the more you may benefit from doing a Roth conversion. Why? As large pre-tax accounts grow, the larger the eventual tax bill becomes, especially when required minimum distributions (RMDs) begin. The converse is also true. If you have not saved a considerable sum in your pre-tax accounts, a Roth conversion is less likely to benefit you.
3. What will my future tax bracket be? You can estimate what your future tax rate will be by projecting retirement income (social security, pensions, investment income, retirement plan distributions from IRAs or 401Ks, etc.) This will obviously be an estimate but provides a baseline for how much you can reasonably make in annual income.  The higher your projected income will be in retirement, the more likely a Roth conversion will benefit you. Again, look at the marginal income tax rate for both then and now.
4. What will future tax rates look like? No one has a crystal ball, but you may feel tax rates will be higher in the future. If income tax is likely to be higher in the future, then paying tax now may benefit you. If you feel tax rates will be lower, it may be better to defer paying the taxes until later, and at a minimum retain the option of when to withdraw and at what prevailing rate.

It is a good idea to consider whether a Roth conversion makes financial sense for you and your family. Keep in mind, current tax law allows you to convert any type of traditional retirement account, and that includes self-directed retirement accounts. In addition, the IRS allows individuals to do both cash conversions and in-kind conversions. An example of an in-kind conversion involves converting an actual asset like a rental property. Furthermore, you can do partial conversions of an account or asset, you are not required to do a full conversion. This allows you to choose a specific amount to convert.

There are several considerations when deciding if a Roth conversion makes sense, and one should always consult a trusted tax advisor, as appropriate, before making any final decisions. If you’d like to learn more about how Roth conversions work, feel free to contact us at (877) 742-1270.