What is a Roth Conversion? Would Doing Conversions Benefit You?

Tax deferred? Tax free? Tax advantaged? It might sometimes feel a bit taxing to think about the tax implications of your retirement savings. But, if you want to increase your estate value or reduce your taxes, then learning about Roth conversions and what they mean for your money is worthwhile.

what is a roth conversion

Roth conversions can be tremendously beneficial in the right circumstances.

What is a Roth Account? What Are Traditional Retirement Savings?

Both Roth (IRAs and 401ks) and traditional retirement savings accounts (IRAs and 401ks) are tax-advantaged. Tax-advantaged means that the account is either exempt from taxation, tax-deferred, or that offers other types of tax benefits.

The main difference between a Roth account and a traditional retirement savings account is the specific tax advantages:

  • Money in a traditional 401k or IRA grows tax deferred, meaning that you will not pay taxes on the money you save and invest into a qualified account, you are deferring that liability. However, you will pay taxes on the money later when you withdraw the funds.
  • Money in a Roth account grows tax free. Contributions to this account are made with after-tax earnings (meaning you pay taxes on the money the year you earn it), but you owe zero taxes when you withdraw the funds – no matter how much the account has grown. 

Another important difference between the two kinds of accounts is that Roth IRAs do not have Required Minimum Distributions (RMDs, money that you must withdraw starting at age 73).

Designated Roth accounts in a 401(k) or 403(b) plan are subject to the RMD rules for 2022 and 2023. However, for 2024 and later years, RMDs are no longer required from designated Roth accounts.

What is a Roth Conversion?

A Roth conversion is when you take money that you have in a traditional 401k or IRA account and move it into a Roth 401k or IRA.

When you convert from a traditional IRA or 401(k) to a Roth IRA, you will need to pay taxes on the amount that you convert, as it was not previously taxed and it is counted as income.

However, once the conversion is complete, future growth and withdrawals from the Roth IRA are tax-free, provided that certain requirements are met.

The NewRetirement Retirement Planner enables you to model a Roth conversions to assess how the move could impact your finances, now and over your lifetime.

Within the Planner, there is also a Roth Conversion Explorer to help you determine the most advantageous time to do conversions to maximize your estate value or to minimize your lifetime tax expenditure.

5 Times When a Roth Conversion Might Be a Great Idea

Roth conversions can sometimes really save you money on taxes, but they could also cost you. It all depends on your circumstances.

While you should always consult a tax expert before doing a Roth conversion, here are 5 times when it will likely benefit you:

1. Higher Future Tax Rate

If you think that you will be paying higher taxes in the future, then converting to a Roth account is probably a good move. Whatever money you withdraw now will be taxed at your current rate but not at all in the future.

Tax considerations to consider might include:

  • Do you intend to relocate in the future? What is the difference between your current and future state’s tax rates?
  • Will you be earning higher income in the future?
  • Will money from Required Minimum Distributions (RMDs) put you in a higher tax bracket?

2. You hope to leave money to heirs 

In many cases, your beneficiaries will pay less in taxes if the money is in a Roth account instead of a traditional account.

If you plan to leave your retirement savings to your heirs, a Roth conversion may be a good idea. Since Roth IRA withdrawals are tax-free, your heirs won’t have to pay taxes on the money they inherit.

3. Your savings are likely to grow significantly

Another situation when a Roth conversion could reduce taxes is when you think that the money in your retirement account will likely grow significantly. If you do a Roth conversion before you see these big gains, then you will be paying taxes on a lower dollar amount and all growth in that account will be tax free.

4. Withdrawals Are a Long Way Off

If you are a long way off from needing to withdraw from your traditional 401k or IRA, then a Roth conversion may be a good idea.

Because Roth IRAs offer tax-free growth, they can be a good choice for long-term investments. If you have a long time horizon, such as 10 years or more, a Roth conversion may be a good idea.

5. You Don’t Need Money from RMDs

If you are already 73 or older, then you have already started taking RMDs. If not, then you will be required to withdraw money from traditional 401ks and IRAs starting at age 73 in 2023 and age 75 in 2033 due to new RMD ages. These withdrawals can be a nuisance and can bump you into a higher tax bracket. 

If you don’t need the income a RMD provides, then it might make sense to convert your traditional accounts to a Roth.

There are a lot of factors that go into Roth conversions. The above rules of thumb may be directionally useful, but it is better to calculate potential conversions in light of your overall financial situation. Learn about using the Roth Conversion Explorer, part of the NewRetirement Planner, to model conversions against the details of your own financial situation and goals.

Rethink a Roth Conversion in These Instances

Can You Afford the Short Term Taxes?

When you take money out of a traditional account and convert it to a Roth account, you will owe taxes on the amount you convert. You need to be sure that you can afford this expense.

NOTE: Many people convert small amounts each year to spread out the tax burden. You do not need to convert an entire account.

You Have a Traditional 401k at Your Current Employer

You usually can not convert a traditional 401k you have with a current employer to a Roth IRA. You must wait until you have left the employer.

The conversion will trigger surcharges or other penalties

When you do a Roth conversion, all of the money you convert from your traditional IRA or 401k will be taxed as income.  However, it is not only the taxes that are costly, the extra income could impact other expenses:

  • College Costs: If you are paying for college, the income could impact financial aid packages.
  • Medicare: If you are 65 or older, the more money you earn (including withdrawals from IRAs and 401ks taxed as income), the more you might need to pay for Medicare.
  • ACA: The rates you pay for health insurance purchased from the Affordable Care Act (ACA) are determined by your income. So, you may want to forgo conversions if it will impact your insurance costs.

You Withdraw the Funds Instead of Converting:

If you withdraw money from a tax advantaged account before you are 59 1/2, then you will usually have to pay a 10% penalty in addition to the income taxes you owe.

This does not mean that you can’t convert the money, you just need to do the right kind of paperwork to transfer your funds from a traditional account to a Roth account. The process usually involves you opening a Roth account and then asking the institution where the account is held to do the paperwork involved with the conversion.

Consult an Expert and Make Sure that Tax Strategies Are Part of Your Overall Retirement Plan

Taxes are confusing and complicated and are perhaps evolving. Before converting money to a Roth account, you may want to collaborate with a CERTIFIED FINANCIAL PLANNER™ professional from NewRetirement Advisors to identify and achieve your goals.

You also want to make sure that your tax strategy is part of your overall retirement plan. NewRetirement Planner is a rich and detailed tool that addresses many different aspects of personal finance, including taxes.

The tool enables you to try different scenarios — including modeling a Roth conversion. You will be able to immediately see your tax differences and compare cash flow, estate value and more before and after the conversion.

PlannerPlus subscribers can even use the Roth Conversion Explorer to get a personalized multi-year Roth conversion strategy to minimize taxes and maximize your estate value.

The NewRetirement Planner makes it easy to take control of your money to live the life you want.

NewRetirement Planner

Do it yourself retirement planning: easy, comprehensive, reliable

NewRetirement Planner

Take financial wellness into your own hands and do it yourself retirement planning: easy, comprehensive, reliable.

Share this post:

Keep Reading

All Posts
Roth conversion strategies Planning

How to Model Roth Conversion Strategies in the NewRetirement Planner

Get a guided walk through of the new Roth functionality and get tips for making the most of the tool. Plus explore all the ways we help you make better decisions about conversions and tax deferred savings.

October 18, 2023
year end tax tips Planning

12 Year-End Tax Planning Strategies to Keep More 2023 Money and Prepare for Future Wealth

These 12 year-end tax tips for retirement will help you minimize your 2023 taxes and reduce future tax bills.

November 2, 2023
Taxes

How to Prepare for the Possible Upcoming Federal Tax Changes

Explore the proposed tax increases on the wealthy and find out what to do about it if you might be at risk of a higher tax burden.

May 6, 2021