What is a Roth conversion, and why should you – or shouldn’t you – do it?

Traditional IRAs and most workplace retirement plans, like 401(k)s, for example, are tax-deferred. That sounds great when you’re adding money to them: no taxes now, deferred growth, wuhoo! 

But tax-deferred is NOT tax-avoided. The tax bill always comes due. The world of IRAs is super-complex, as is the world of income-tax brackets. They come together in a perfect storm of complexity. HOWEVER, there are some easier pieces to explain. Without getting into every scenario and making this overly complicated, here is the core idea:

If you’re going to be in a lower tax bracket this year than you foresee being in next year, it’s a good idea to STOP tax-deferring: pay it now, instead. Deferring to a year with a higher bracket is bad. We don’t like paying taxes before we have to, but we hate paying MORE in taxes than we’d have to even more.

So each year when I do tax planning I run projections about your “terminal tax bracket”, i.e., what your steady state will be in retirement. If it’s the same or higher than you’re in now, I figure out how much of the IRA we can convert without adding a damaging amount of taxes. We can convert any amount of your Traditional IRA, up to the entire amount, to a Roth IRA. This is called a “Roth Conversion”. It declares “I’m going to stop deferring and pay the taxes now.”

The reason we do this is that you can save a LOT of money by doing a Roth conversion at the right moment. It’s not unusual for me to get an IRA taxed at 12% when it would otherwise have been taxed at 22%, saving not only 10% straight up for always, but ALSO getting any future earnings exempt from taxes, meaning a $10K Roth conversion quite possibly saves $1,000 in taxes. Not always, and sometimes it saves the money for your heirs, but it’s likely enough that it’s always worth looking for. 

There are a LOT of things that influence whether to do a Roth conversion (feel free to skip this, but in case you’re interested):

  • Whether you’re single or married or recently widowed: people move into higher brackets when they go from “joint” to “single”, e.g., when someone dies. Alternatively, they go into a lower bracket when they go from single to married, so if you’re planning to couple up, it affects this.
  • Whether you have any large windfalls planned – selling property with a large capital gain, for example.
  • Whether you have any expiring tax credits – sometimes we’ll do a Roth conversion to use up a tax credit you wouldn’t otherwise use.
  • What’s going on with the IRMAA thresholds for medicare recipients – it’s like a parallel tax bracket system that I have to stop and watch
  • What’s going on with tax brackets, including on investment income – there are some surcharges on investment income if your income goes too high – 
  • The phase-in of the taxability of your social security income.
  • The phase OUT of education credits and subsidized health insurance and Circuit Breaker Tax Credits… we’ve got a LOT of income-based benefits to watch for.
  • Whether you’re trying to apply for financial aid for a college student
  • Whether you expect to need these funds sooner or later

I wrote this article in general terms, but it stops being general about five minutes into the conversation. It’s sort of the point of having an advisor who knows YOUR situation.