Roth IRA conversions: Pros & cons (2024)

FAQs

Roth IRA conversions: Pros & cons? ›

Transforming your retirement savings. Funding a Roth IRA is appealing chiefly because doing so can give you tax-free income in retirement. The trade-off, however, is that you fund a Roth with after-tax money, meaning you don't get a tax deduction today. Plus, if your income is too high, you can't fund a Roth.

Since a Roth conversion increases taxable income in the conversion year, drawbacks can include a higher tax bracket, more taxes on Social Security benefits, higher Medicare premiums, and lower college financial aid.

Deciding whether to convert assets to a Roth IRA depends largely on what you anticipate that your future income tax bracket will be. The conversion could be especially beneficial if you expect to be in a higher tax bracket in retirement—you'll pay the taxes now at your lower current rate.

Making in-plan Roth conversions while an investor's income is still taxed at the ordinary tax rate is a good strategy. This means they'll pay much less in taxes now, rather than pay higher conversion taxes later.

If you believe your tax rate is lower now than it will be when you start taking withdrawals, a conversion may look promising because you'll pay conversion taxes while you're in a lower tax bracket and enjoy tax-free Roth IRA withdrawals later (when the higher tax bracket won't matter).

However, there are no limits on conversions. A taxpayer with a pre-tax IRA can convert any amount of funds in a year to a Roth IRA. Roth IRAs also are exempt from required minimum distributions (RMDs). These mandatory withdrawals from retirement accounts begin at age 72 and can create a tax burden on affluent retirees.

There is no way to avoid paying taxes on a Roth conversion. However, you can lower your tax burden by timing the conversion right.

The Roth IRA five-year rule

The five-year rule could foil your withdrawal plans if you don't know about it ahead of time. This rule for Roth IRA distributions stipulates that five years must pass after the tax year of your first Roth IRA contribution before you can withdraw the earnings from the account tax-free.

You need the liquidity outside of your IRA to pay the taxes due. If you are converting $100,000 you need to have between $30,000 and $41,000 to pay the taxes. Assuming your Roth IRA can grow at a 6% rate of return, it will take you a minimum of 10 years to break even.

You're never too old to fund a Roth IRA. The earlier you start a Roth IRA, the longer you have to save and take advantage of compound interest. Even when you're close to retirement or already in retirement, opening this special retirement savings vehicle can still make sense under some circ*mstances.

Is now a good time to do a Roth conversion? ›

After you stop working, but before you start required withdrawals from retirement accounts, is “the sweet spot” for Roth conversions, according to JoAnn May, a Berwyn, Illinois-based certified financial planner at Forest Asset Management.

You'd owe income tax on the entire amount that you convert from a traditional IRA into a Roth IRA in the year you make the switch. The amount of tax will depend on your income tax bracket and income tax rate—between 10% and 37% as of 2024. 1 The money you convert is added to your gross income for the tax year.

In either case, you could end up in a higher tax bracket due to your Roth IRA conversion, resulting in a higher tax liability. “Keep in mind that the conversion may also be subject to state income taxes depending on the income tax rules of the state that you reside in,” Yeung said.

Impact of future tax bracket. You believe that you will be taxed at the same rate or higher when you begin taking withdrawals. Therefore, converting some of your retirement assets to a Roth IRA could make sense, allowing for tax-free withdrawals in the future, when you expect your federal income tax to be higher.

Sources of retirement and investment income are specifically excluded from the Social Security benefit calculus. That includes Roth conversions. At first blush, that may seem like you are getting a raw deal. You pay taxes on that income, but then you don't get the benefit in the form of higher Social Security benefits.

You must report any amount converted from a tradi- tional to a Roth IRA on your federal income tax return. Unless you choose otherwise, the IRS requires 10% of the conversion amount be withheld by URS for federal income tax purposes. You may elect to have no taxes withheld or elect to have more than 10% withheld.

Although opening a "backdoor" Roth IRA may sound shady, don't let the name mislead you. It's a totally legal loophole. At its core, a backdoor Roth IRA is a simple conversion: You put money into a traditional IRA or 401(k), then convert it to a Roth IRA.

The Five-Year Rule

The best time to convert from a traditional to a Roth IRA is generally when the market is down and your traditional IRA has lost value, and/or your income is unusually low, and/or your itemized deductions for the year have increased.