A Roth conversion can potentially save you thousands of dollars in taxes, but it’s not right for everyone. In this blog, I cover the basics of Roth conversions and how they can be used in financial planning, but a final decision on whether or not a Roth conversion can work for you requires individual planning.

We have software that helps us analyze your situation and the tax implications of Roth conversions. The software spits out 41 different scenarios. Then, we use our expertise to pick out the top ones, and together with you, we decide on whether a Roth conversion makes sense.

This is the time of year to start thinking about Roth conversions because they must be finalized by the end of the year and cannot be taken back.

How does a Roth conversion work?

A Roth conversion is just as the name implies! You take money that is in a traditional IRA and convert it to a Roth IRA. The basic idea is that we’re changing the tax status on the money. The difference between Traditional IRAs and Roth IRAs is that when you are taxed, you get to put money into a traditional IRA tax-free, and then when you start taking the money out in retirement, you pay ordinary income taxes on it. This is how most retirement plans, like 401(k)s work too. Roth IRAs are the opposite. You pay taxes on the money you put into them, but take the money out tax-free.

With a Roth conversion, you pay taxes now so that—under current law—you never have to pay taxes again. This means that all the money subject to the conversion is counted as ordinary income. So if you’re not careful, you can unintentionally create a massive tax liability. Why would anyone want to do one then?

How might a Roth conversion benefit you?

Because the money in a traditional IRA has never been taxed—under current law—the government forces you to withdraw the money each year once you turn 70 ½. They call this an RMD (required minimum distribution). The percentage you must withdraw from your account increases each year as you get older, and eventually, it may be much higher than what you actually need to live on.

This means that you might end up paying much more in taxes than you need to. Here’s where Roth conversions come in. If you convert some money to a Roth ahead of time, you pay taxes now, but you can potentially save yourself much more in taxes in the future—when it may be even more important to do so for medical or other reasons.

Roth IRAs are also better to leave to heirs than traditional IRAs. When your children—or other heirs —inherit a Roth IRA, they don’t have to pay any taxes on the money they take out. This is helpful because when someone inherits an IRA, they must start taking money out immediately, even if they’re working. With a traditional IRA, they may end up paying more in taxes than they want to, but with a Roth, there is no tax burden.

When should you do a Roth conversion?

Roth conversions may not make sense for everybody. It really comes down to your unique situation; in some cases, it could save tens of thousands in taxes, in others, it may cost more in taxes. Always have us evaluate your situation before deciding to pull the trigger on a Roth conversion.

Also, remember, we are talking about Roth conversions, not Roth contributions. You may be wondering, If Roth conversions are so great, why don’t I just contribute all I can to them when I’m working in the first place?

Two reasons: First, when you’re working, your tax bracket is usually higher, so you have to pay more in taxes to get the money into the Roth than you would if you converted after you stop working—more on this below. (Also keep in mind whether to contribute to a Roth in your working years or not requires some sophisticated planning to analyze your unique situation. Don’t listen to generic advice like, “Always do Roth when you’re young,” etc.) Second, the annual limit for Roth contributions is $6,000, while Roth conversions are unlimited.

Here are the factors that generally make Roth conversions more likely to work for you:

1. If you have recently retired or are nearing retirement.

Once you retire, you probably no longer have earned income coming in, and so your tax bracket is usually lower than it was before retirement. This means we can convert more money to Roth while paying less taxes than we could while you were working.

For example, many people are in a 22% tax bracket when working but drop down to the 12% when they are in retirement. If we tried to contribute to a Roth or do a Roth conversion while working, we pay 22% taxes on that money. If we wait until retirement, we can convert at the 12% bracket or even lower, thus saving money on taxes.

2. If most of your money is tied up in pre-tax accounts (traditional IRAs, 401(k)s, 403(b)s, SEPs, SIMPLEs, etc.)

One of the goals of Roth conversions is what we call “tax diversification.” Just like we diversify our investments in different asset categories because we never know what the market will do, we like to diversify our accounts with different types of taxation because we never know what the government will do. If most of your money is tied up pre-tax, you don’t have much tax diversification going for you. Having money in both pre-tax and post-tax (and non-qualified) accounts gives you more flexibility for taking income in retirement and for your estate plan.

Tax diversification is also why we don’t usually recommend converting everything to Roth. For example, the federal government could decide to enact more national sales or consumption taxes. We currently pay state sales taxes in most states on everything we purchase, but we only pay federal sales tax on a select few things like gas, alcohol, or tobacco. Europe, however, already has a system with high consumption taxes.

If the US went that route, Roth IRAs would lose some of their benefits. With a Roth, you pay taxes up front, and then withdraw the money tax-free. But if you have money in Roth IRAs, and then the government adds a federal sales tax, you now must pay taxes with that money when you make purchases too—you’ve been double taxed. This is why we like tax diversification.

3. If you have some non-qualified money.

Non-qualified accounts are “pay as you go” accounts, where you are taxed on dividends and interest each year and then when you make withdrawals you usually pay lower long-term capital gains rates. Non-qualified accounts are not necessary for a Roth conversion to work, but they do make them more efficient because we can use the non-qualified account to pay the taxes generated by the Roth conversion.

For example, let’s say I have $100,000 to convert to a Roth, I’m married filing jointly, and for the sake of simplicity, I have no other income. This would generate taxes of $8,739 in 2018. The standard way to pay this amount would be to take it out of the conversion. So instead of converting $100,000 to Roth, now I only convert $91,261—the $8,739 is lost to the government. If, instead, I pay those taxes with non-qualified money, I can convert the full $100,000. Roth IRAs also have more tax advantages than non-qualified accounts, so it makes sense to take the hit on the non-qualified while getting to convert more to the Roth.

This is an introduction to the subject, and each situation must be looked at and analyzed individually, but if this seems like something that might be right for you, give us a call today!


Written by Michael Sharpnack

*Advisory services offered through Paul Winkler, Inc. (‘PWI’), a Registered Investment Advisor. PWI does not provide tax or legal advice: Please consult your tax or legal advisor regarding your particular situation. This information is provided for informational purposes only and should not be construed to be a solicitation for the purchase or sale of any securities. Information we provide on our website, and in our publications and social media, does not constitute a solicitation or offer to sell securities or investment advisory services, or a solicitation to buy or an offer to sell a security to any person in any jurisdiction where such offer, solicitation, purchase, or sale would be unlawful under the securities laws of such jurisdiction.