For many Americans approaching retirement, one of the biggest financial concerns is how much they'll owe in taxes once they begin withdrawing money from their retirement accounts.
After decades of contributing to traditional IRAs and employer-sponsored retirement plans, retirees may find themselves with substantial savings that have never been subject to income tax.
While these accounts can provide valuable tax-deferred investment growth, withdrawals are generally subject to ordinary income taxes to the extent they consist of previously untaxed amounts.
This is where a Roth conversion may become an important retirement planning strategy.
A Roth conversion allows you to move money from a traditional retirement account into a Roth IRA, generally paying income taxes on the converted amount today in exchange for the potential to receive tax-free qualified withdrawals in the future.
However, Roth conversions aren't necessarily appropriate for everyone.
Understanding how they work, when they may be beneficial, and the potential tax consequences can help you determine whether this strategy deserves a place in your retirement plan.
What Is a Roth Conversion?
A Roth conversion is the process of moving eligible retirement assets from a traditional IRA or another eligible retirement plan into a Roth IRA.
Traditional retirement accounts generally allow investment earnings to grow tax-deferred. Withdrawals attributable to previously untaxed contributions and earnings are generally subject to ordinary income taxes.
Roth IRAs operate differently.
Although contributions to Roth IRAs aren't deductible, qualified withdrawals are generally free from federal income tax.
When you convert money from a traditional IRA to a Roth IRA, the amount that has not previously been taxed is generally included in your taxable income for the year of conversion.
For example, suppose you have $500,000 in a traditional IRA consisting entirely of previously untaxed funds.
You decide to convert $50,000 into a Roth IRA.
Assuming the entire conversion is taxable, the $50,000 would be included in your gross income for that tax year and generally subject to ordinary income taxation.
The remaining $450,000 would stay in your traditional IRA, assuming no other transactions or changes in investment value.
The converted funds would then be held in your Roth IRA, where future qualified distributions could be received tax-free.
Importantly, a Roth conversion doesn't require you to convert your entire traditional IRA balance at once.
You can generally convert a portion of your eligible retirement assets, allowing you to evaluate the tax consequences of different conversion amounts.
Why Consider Roth Conversions in Retirement?
The primary objective of a Roth conversion is to change the tax treatment of retirement savings.
Instead of leaving all your retirement assets in accounts that may generate taxable income when withdrawn, you intentionally recognize taxable income today to move some assets into a Roth IRA.
Whether this creates a financial benefit depends on several factors, including your current tax situation, anticipated future tax rates, retirement income needs, and the amount of time your converted assets may remain invested.
Here are several reasons retirees may consider this strategy.
1. Taking Advantage of Lower-Income Years
One potential opportunity for Roth conversions occurs during years when your taxable income is lower than usual.
For example, someone who retires at age 62 may experience a significant reduction in earned income after leaving the workforce.
If they delay claiming Social Security and aren't yet required to take minimum distributions from their traditional retirement accounts, they may have greater flexibility over how much taxable income they recognize.
This period between retirement and the beginning of other retirement income sources can create an opportunity to evaluate Roth conversions.
Consider an individual who previously earned a substantial salary but now relies primarily on taxable brokerage account withdrawals to cover living expenses.
Depending on the composition of those withdrawals and other income sources, their taxable income may be considerably lower than it was during their working years.
Converting a portion of their traditional IRA during these years may allow them to recognize income at a lower marginal tax rate than they anticipate paying in the future.
However, this outcome isn't guaranteed.
The potential benefit depends on the tax rate paid on the conversion compared with the tax treatment of future distributions, along with other financial considerations.
2. Potentially Reducing Future Required Minimum Distributions
Traditional IRAs are generally subject to required minimum distribution (RMD) rules.
These rules require account owners to begin withdrawing minimum amounts from applicable retirement accounts once they reach the required beginning age, subject to the rules governing their particular accounts.
RMDs from traditional IRAs generally create taxable income to the extent distributions consist of previously untaxed amounts.
For retirees with substantial traditional IRA balances, required distributions may become a significant source of taxable income later in retirement.
A Roth conversion can potentially reduce future RMDs by decreasing the amount held in traditional retirement accounts.
For example, converting a portion of a traditional IRA into a Roth IRA reduces the traditional IRA balance that would otherwise remain subject to future RMD calculations, assuming all other factors remain equal.
Under current federal law, Roth IRAs are not subject to required minimum distributions during the original account owner's lifetime.
This distinction can provide greater flexibility when determining how and when to withdraw retirement assets.
However, Roth conversions do not eliminate RMD obligations that have already arisen. Amounts required to be distributed as RMDs for a particular year cannot be converted into a Roth IRA.
Source: Internal Revenue Code § 401(a)(9); IRS Publication 590-B.
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3. Creating a Source of Potentially Tax-Free Retirement Income
Another potential benefit of Roth conversions is creating a source of retirement income that may be withdrawn tax-free.
Qualified distributions from Roth IRAs are generally excluded from federal gross income.
For a Roth IRA distribution to be qualified, it must satisfy the applicable five-year requirement and meet an additional qualifying condition, such as being made after the account owner reaches age 59½.
Other qualifying circumstances may apply.
For retirees who meet these requirements, Roth IRA withdrawals can provide a source of income without increasing federal taxable income.
This flexibility may be valuable when coordinating withdrawals among traditional retirement accounts, taxable brokerage accounts, and Roth IRAs.
Rather than relying exclusively on taxable distributions from traditional retirement accounts, retirees may have additional options for funding expenses while managing taxable income.
It's important to understand that Roth IRA distribution rules can be complex, particularly for individuals who make conversions before age 59½.
Certain early distributions of converted amounts may be subject to additional tax rules, even when the original conversion was properly completed.
Source: IRC § 408A; IRS Publication 590-B.
4. Managing Future Tax Exposure
One of the central considerations in evaluating a Roth conversion is the relationship between your current and anticipated future tax rates.
When you convert previously untaxed retirement assets into a Roth IRA, you generally recognize ordinary income in the year of conversion.
In exchange, future qualified withdrawals from the Roth IRA are generally excluded from federal income taxation.
This creates an important planning question:
Would you rather pay income taxes on these retirement assets today or potentially pay taxes when you withdraw them in the future?
If you expect to face a higher marginal income tax rate later in retirement, converting some retirement assets while your current tax rate is lower may be beneficial.
Conversely, if your current tax rate is significantly higher than the rate you expect to pay on future traditional IRA withdrawals, a conversion may be less attractive.
The comparison isn't always straightforward.
Future tax laws, investment performance, retirement income needs, and the timing of withdrawals can all affect the outcome.
For this reason, Roth conversions should generally be evaluated using multiple financial planning scenarios rather than relying on assumptions about future tax rates alone.
5. Understanding the Impact on Medicare Premiums
While Roth conversions may provide long-term tax planning opportunities, they can also create unintended consequences.
One important consideration for retirees enrolled in Medicare is the Income-Related Monthly Adjustment Amount, commonly referred to as IRMAA.
Medicare uses modified adjusted gross income to determine whether certain beneficiaries must pay additional premiums for Medicare Part B and Part D.
These income-related adjustments are generally based on tax return information from two years earlier.
Because the taxable portion of a Roth conversion generally increases adjusted gross income, a conversion may cause a retiree's income to exceed an applicable IRMAA threshold.
This could result in higher Medicare premiums in a subsequent year.
For example, a retiree who completes a substantial Roth conversion may experience an increase in taxable income during the conversion year.
If that additional income places them above an applicable IRMAA threshold, their Medicare premiums may increase when that tax year's income is used to determine the adjustment.
This doesn't necessarily mean the Roth conversion was a poor financial decision.
However, potential Medicare premium increases should be considered when evaluating the overall cost and benefit of a conversion.
Source: Social Security Administration and Medicare.gov guidance on income-related Medicare premiums.
6. How Roth Conversions Can Affect Social Security Taxation
Roth conversions can also affect the taxation of Social Security benefits.
Under federal tax rules, the amount of Social Security benefits included in taxable income depends partly on a calculation involving other income.
The taxable portion of a Roth conversion generally increases adjusted gross income, which can cause a greater portion of Social Security benefits to become taxable.
Depending on the individual's circumstances, up to 85% of Social Security benefits may be included in federal taxable income.
This doesn't mean Social Security benefits are taxed at an 85% rate. Rather, it means that up to 85% of the benefits received may be subject to income taxation.
For retirees already collecting Social Security, this interaction should be evaluated before implementing a conversion.
Source: IRC § 86; IRS Publication 915.
Should You Convert Your Entire Traditional IRA at Once?
Not necessarily.
Although eligible taxpayers can generally convert substantial amounts from traditional IRAs into Roth IRAs, converting a large balance in a single year may create a significant income tax liability.
Because taxable Roth conversions generally increase ordinary income, a large conversion may push portions of your income into higher marginal federal income tax brackets.
This is one reason some retirees consider spreading conversions across multiple tax years.
Instead of converting an entire traditional IRA balance at once, a retiree might evaluate smaller annual conversions based on their projected taxable income.
For example, someone with a substantial traditional IRA balance might consider converting a portion of that balance each year during a period of relatively low taxable income.
This approach is sometimes called a Roth conversion ladder.
However, converting smaller amounts over multiple years isn't automatically superior to making a larger conversion.
The appropriate strategy depends on the taxpayer's circumstances, anticipated tax rates, time horizon, and broader retirement income plan.
Important Considerations Before Completing a Roth Conversion
Before converting traditional retirement assets into a Roth IRA, there are several important factors to consider.
Your current marginal tax rate: The taxable portion of a Roth conversion generally increases ordinary income, potentially affecting the marginal rate applied to additional income.
Your anticipated future tax rate: The potential benefit depends partly on how the tax treatment of a conversion today compares with future distributions.
Your ability to pay the conversion taxes: Paying conversion-related income taxes using assets outside the retirement account may preserve more money inside the Roth IRA, although the alternative uses of those outside assets should also be considered.
Your Medicare premiums: Additional taxable income from a conversion may affect income-related Medicare premium adjustments.
Your Social Security benefits: A taxable conversion may increase the portion of Social Security benefits included in taxable income.
Your investment time horizon: The length of time converted assets remain invested may influence the long-term outcome of a conversion strategy.
Your retirement spending needs: Conversions should be coordinated with anticipated withdrawals and other sources of retirement income.
Your existing IRA tax basis: If you have nondeductible contributions in traditional IRAs, special rules determine the taxable and nontaxable portions of a conversion. You generally cannot simply select only after-tax dollars for conversion from accounts subject to the IRA aggregation rules.
Another important consideration is that Roth conversions generally cannot be reversed through recharacterization under current federal tax law.
This makes it especially important to understand the tax consequences before completing a conversion.
Final Thoughts: Are Roth Conversions Right for You?
Roth conversions can be a valuable retirement tax planning strategy, but they aren't appropriate for everyone.
For some retirees, converting traditional retirement assets during lower-income years may provide an opportunity to manage future taxable income and reduce the amount remaining in accounts subject to required minimum distributions.
For others, the immediate tax liability or impact on Medicare premiums and other income-related calculations may outweigh the potential benefits.
The decision should not be based solely on whether Roth IRAs offer tax-free qualified withdrawals.
Instead, it's important to evaluate how a conversion fits into your broader retirement income strategy.
At Morrissey Wealth Management, we believe effective retirement planning requires understanding how taxes, investments, Social Security, and retirement withdrawals interact.
By evaluating different Roth conversion scenarios as part of a comprehensive financial plan, you can make more informed decisions about how to manage your retirement assets and long-term tax exposure.
If you're approaching retirement or already retired, working with a financial planner can help you determine whether Roth conversions may be appropriate for your financial situation.
As always have a wonderful day,
a better weekend,
and I look forward to writing to you next Friday!
Written by Ryan Morrissey CFP®, CLU®, CHFC®, CMFC
Founder & Principal Advisor of Morrissey Wealth Management
Host of the Retire with Ryan Podcast