Perspectives

Roth IRA Conversion: Is It Right for You?

Moving some or all of the assets from your Traditional IRA into a Roth IRA may provide you with greater financial flexibility in retirement but could have tax consequences in the near term.

A fairly simple financial move can create significant advantages for many investors: converting a Traditional individual retirement account (IRA) to a Roth IRA. While it may not be the right choice for everyone, Roth conversions can help many investors increase their future financial flexibility in retirement. “Every investor may want to consider gaining some exposure to Roth IRAs,” says Judith Ward, CFP®, a senior financial planner at T. Rowe Price. “For retirees, having a Roth IRA can increase their after-tax income, since withdrawals from the account are income tax-free and may be made at the discretion of the investor.”*

SHOULD YOU CONVERT

There are a number of benefits to owning a Roth IRA. The tradeoff from converting is that moving assets from a Traditional IRA to a Roth IRA generally requires paying taxes at the time of the account conversion rather than later, when you start taking withdrawals. And a Roth IRA conversion generally will result in an increase to your taxable income, potentially pushing you into a higher marginal tax bracket. 

Deciding whether to convert assets to a Roth IRA depends in part on what you anticipate 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. That said, the move may be advantageous even if you think your tax rate will stay the same or decline. “The longer you have until retirement, and the longer you live in retirement,” Ward says, “the more time you have for a Roth IRA’s potential tax-free growth to make up for the taxes you paid originally on the conversion amount.”

And Roth IRAs do not have required minimum distributions (RMDs), which makes them a valuable retirement and estate planning tool. If you don’t need to make withdrawals during retirement, you can leave those assets—and any tax-free earnings they generate—to your heirs. “The amount you pass on to heirs can continue to grow tax-free in their Inherited Roth IRAs,” Ward notes. “Your heirs will be required to take RMDs each year, and they can always withdraw more whenever they need it. Leaving a Roth IRA to a beneficiary is one way to generate potential tax-free income for your loved one.”

COVERING THE COST OF CONVERSION

Before converting, consider each of the following strategies for paying the taxes.

  • Stagger the conversion. If a Roth IRA conversion would push you into a higher federal tax bracket, consider conducting multiple partial conversions over a period of a few years.
  • Pay conversion taxes with non-IRA assets.Generally speaking, it’s ideal to pay taxes on the conversion from a taxable account. Withdrawing from a Traditional IRA would result in unnecessary additional taxes. And if you tap the Traditional IRA when you’re younger than age 59½, your withdrawal will be subject to a 10% early withdrawal penalty.
  • Consider a tax-free withdrawal from a Roth IRA.  If you don’t have enough savings available to pay the taxes, consider taking a tax-free withdrawal from your new Roth. Although this approach may sound counterintuitive, the reason you are converting to a Roth IRA now is to maximize the number of years your assets can grow tax-free before you or your heirs ultimately need to take withdrawals. 

While converting at least some of the assets in your Traditional IRA into a Roth IRA may provide you with considerable advantages, especially in retirement, talk with your financial advisor about each of the above considerations before making your decision.

*Earnings may be subject to taxes and penalties if distributed before age 59½ or before the account is five years old.

A Comparison:

Both Traditional IRAs and Roth IRAs offer tax advantages. “With a Traditional IRA, you have to start taking RMDs from the account each year once you reach age 70½,” says Ward, referring to the RMDs on Traditional IRAs. “Since each withdrawal amount is generally treated as ordinary income, you may be forced to pay taxes on withdrawal amounts you don’t even need. With a Roth IRA, there are no required minimum distributions, and you can make qualified withdrawals without paying taxes.”

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