How a Roth Conversion Can Reduce Taxes in Retirement

Moving money from a pre-tax savings account such as a 401(k) or Traditional IRA into a Roth IRA can offer long-term tax benefits. But it’s not the right choice for everyone, and timing is critical. 

In this article, we’ll explain how to:

• Rollover an IRA into a Roth
• Convert a 401(k) into a Roth
• Time your move to avoid tax consequences

What’s the difference between a Traditional IRA and a Roth IRA?

Before diving into the details about how and when to move assets into a Roth IRA, let’s review the basic difference between a traditional IRA and a Roth IRA.

• A traditional IRA is funded with pre-tax dollars. Contributions reduce taxable income the year they are invested, but taxes must be paid on withdrawals.
• A Roth IRA uses after-tax dollars. Instead of deferring money from your paycheck, you transfer money that’s already been taxed into the account. Your money grows tax-free and you don’t pay taxes when you take money out…if you follow the rules.

What Is a Roth Conversion?

When you move money from a pre-tax retirement savings account such as a traditional IRA, 401(k) or 403(b) into a Roth IRA, that’s called a Roth conversion. You can convert some or all of the money in your pre-tax account into a Roth, but because that money hasn’t been taxed, it’s considered income and taxed at your ordinary income tax rate.

Why would anyone want to do this? If you expect to be in a higher tax bracket when you retire, it can be beneficial to pay taxes now.  

This strategy is often utilized by:

• Recent retirees who are now in a lower tax bracket
• People who’ve lost their job
• Workers who have a low-income year

If you have a sizable amount of money to convert, it may make sense to spread conversions over a few years. For example:

A single taxpayer will pay 24% tax on income between $100,526 and $191,950 (based on the 2024 tax rates). If the taxpayer moves $100,000 assets into a Roth, they’ll pay 32% tax on income over the $191,950 threshold. At $243,725, an even higher tax rate goes into effect. 

Put another way, if you don’t plan ahead, you can end up paying more tax than necessary. A wealth manager can calculate how much to invest and when. 

One More Reason To Do a Roth Conversion

Unlike traditional IRAs, a Roth IRA doesn’t have required minimum distributions (RMDs). Having some of your retirement savings in a Roth gives you more control over your taxable income in retirement. You can leave the funds in your Roth as long as you wish, allowing those funds to continue to grow tax-free and then leave the remainder to your heirs.

Are there Roth conversion limits?

There is no limit to how much money you move into a Roth IRA. However, as mentioned above, the amount converted increases your tax liability.

There are also no income or contribution limits for Roth conversions. Even if your income exceeds the limits for making contributions to a Roth IRA, you can still do a Roth conversion. This is known as a “backdoor Roth IRA."

The Best Time to Convert to a Roth IRA

The best time to convert assets from your pre-tax retirement savings account to a Roth IRA depends on several factors:

1. Your Current Tax Bracket: The best time to convert money to a Roth is when your income is unusually low, or you have losses that can reduce the tax impact of the conversion.
   
   
2. Your Future Tax Bracket: If you expect to be in a higher tax bracket in the future, paying taxes now might make sense.
   
   
3. When You Can Afford the Additional Income Tax: A financial advisor can help you estimate the additional amount you’ll owe.
   
   
4. As Part of a Long-Term Estate Plan: A Roth can be part of a long-term strategy to leave money to loved ones. The assets grow tax-free and withdrawals are tax-free, but only if the Roth account has been established for at least 5 years. 

Roth Conversions: the 5-Year Rule

There’s another 5-year rule to be aware of: each conversion you make has its own 5-year waiting period before you can withdraw the converted amount penalty-free.  

So, if you convert $10,000 in 2025, you can’t touch that money (without penalty) until 2030 unless you're over age 59½. If you're younger than 59½, you may owe a 10% penalty. The IRS does make exceptions for people with a terminal illness diagnosis, residents of a federally designated disaster area and other reasons.

When NOT to Convert to a Roth IRA

For some people, Roth conversions are a financially savvy move. But if any of the scenarios below apply to you, consider keeping your money where it is. 

• You expect to be in a lower tax bracket in retirement.
• The conversion will push you into a higher tax bracket this year.
• You’d have to dip into savings to pay the tax bill.
• You receive Social Security, Medicare or benefit from income-based programs, such as healthcare subsidies from the Affordable Care Act.
• You're close to retirement and may need the money in less than five years.
• You don’t have a long time horizon for the money to grow.
• You have a traditional IRA and plan to donate to a charity through Qualified Charitable Distributions (QCDs). This strategy satisfies RMD requirements and you pay zero tax.

Get Expert Advice About Roth Conversions

Choosing whether to convert assets into a Roth IRA is a personal decision that depends on your unique financial situation and goal. If you’re unsure if a Roth conversion is right for you, our friendly and helpful wealth managers can help you make an informed decision. Connect with a financial expert online or give us a call at (415) 541-7774.

Related Reading:

• The Smart Way to Leave Assets to Your Heirs
• Multiple Retirement Accounts? Here’s What To Consider…
• The Benefits of Investing Early for Retirement

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