Executive Summary

A Roth conversion allows investors to pay taxes today in exchange for tax-free growth on qualified future withdrawals.

• Conversions can be especially effective during low-income years, market downturns, or periods before required minimum distributions begin.
• While Roth conversions offer long-term tax and estate planning benefits, they can also create short-term tax consequences if not executed carefully.
• Avoid poor investment choices derived from emotion around taxes.  

What Is a Roth Conversion?

A Roth conversion is the process of transferring assets from a tax-deferred Traditional IRA into an after-tax Roth IRA.  Conversions may also be available under a workplace retirement plan (401K or 403B), but plan documents will dictate availability. 

What is the Tax Treatment?

The amount converted is considered taxable in the year of conversion, and it is taxed at the same rates as all other sources of personal income (i.e., Rental Income, Interest, Dividends, W-2, 1099, etc.).

Once moved into the Roth IRA, the resulting funds can be invested for continued growth, and qualified withdrawals are generally tax-free. The deadline for conversions is December 31^st. 

Potential Benefits of Roth Conversions

Roth conversions may be attractive for several reasons, including:

• Tax-free growth and withdrawals: Qualified distributions from a Roth IRA are not subject to federal income tax.

• Tax rate arbitrage: Paying taxes today may be advantageous if it allows avoidance of paying higher tax rates in the future.

• No required minimum distributions (RMDs): Roth IRAs do not have an RMD requirement, which allows assets to remain invested longer.

• Estate planning advantages: Beneficiaries generally receive Roth IRA distributions income-tax free, which can be valuable for heirs in higher tax brackets.

When Are Roth conversions Most Effective?

The timing of a Roth conversion can significantly impact its success.  Situations that may warrant consideration may include:

• Low-income years: Years between retirement and the start of Social Security or pension income often present favorable tax windows.

• Temporary income reductions: Career transitions, business losses, or other short-term income declines may reduce the tax cost of a conversion.

• Market volatility or downturns: Converting when account values are lower can allow more shares to be converted at a lesser tax liability. Also, any resulting market recovery would grow tax-free in the Roth IRA.

• Special tax situations: Higher deductions, tax credits, or capital losses can help mitigate the tax impact of a conversion.

Key Considerations and Potential Pitfalls

Despite their advantages, Roth conversions also carry important trade-offs:

• Immediate tax liability: Conversions increase taxable income and may push investors into higher marginal tax brackets.  Also consider how much time and growth are required to recoup the taxes you paid upfront at the time of conversion.

• Emotional decisions: Investors can be driven to make investment decisions out of emotional disapproval of taxes. Make sure the tax “tail” doesn’t wag the “investment” dog. 

• Medicare and tax ripple effects: Higher income can trigger Medicare premium surcharges or reduce eligibility for certain deductions and credits (such as the “Senior Bonus” Deductions).

• Source of tax payments: Paying conversion taxes from retirement assets can diminish the long-term benefits of the strategy. Paying from after-tax assets is preferable.

• Unknown factors: If future tax rates are lower than expected, it may be preferable to continue deferring taxes through a Traditional IRA. If decreased longevity is a concern, continuing with a Traditional IRA and forgoing a Roth conversion may also be the best choice.

A Flexible and Strategic Decision

Roth conversions are best viewed as a flexible, ongoing planning tool rather than a one-time event. Many investors choose to:

• Convert portions of their accounts over several years to better manage tax brackets.

• Coordinate conversions with other planning decisions, such as Social Security timing and charitable giving.

• Evaluate annually as tax laws, income levels, and market conditions evolve.

Final Thoughts

Roth conversions are not a cure-all for tax planning. The decision to convert should always be made within the context of a comprehensive financial plan. Working closely with a financial advisor and tax professional can help ensure Roth conversions are executed efficiently and aligned with your broader objectives.