What To Know About Roth Conversions and Your Taxes
June 14, 2023
What To Know About Roth IRA Conversions and Your Taxes

Roth IRAs

Roth IRAs have become an important part of Americans’ retirement planning since their introduction in 1997. By 2022, contributions to Roths outpaced those to traditional IRAs by almost 2 to 1. 

As a tax-advantaged retirement account, a Roth IRA is funded with after-tax contributions; you pay tax on the money you contribute to your Roth account when that money is earned. Starting at age 59-1/2 you can make withdrawals of both your contributions and earnings tax-free. You are never required to take distributions and can designate a beneficiary to inherit your account with no income taxes ever due.  


Traditional IRAs

In contrast, traditional IRAs are funded with pre-tax dollars. Your taxable income is lowered in the year you make contributions to your traditional IRA or 401(k) so you pay no tax when you contribute. However, because you do not pay federal income tax on your contributions to a traditional account, the government will tax any distributions from your account as ordinary income. You can delay taking distributions, but not forever. Depending on the year you were born you will be required to start withdrawing Required Minimum Distributions (RMDs) at 72, 73, or 75. 


Should you contribute to a Roth or Traditional IRA?

The conventional wisdom is that most people have a low tax rate early in their careers. Their rate rises as their income increases and then drops down after retirement.  Assuming this pattern holds, making after-tax Roth contributions during the early years and then switching over to pre-tax regular contributions would be optimal for many people.   


When a Roth is the Better Choice

Contributions to a traditional IRA aren’t necessarily good for everyone for their entire career. If you know that you will be at a higher tax rate in retirement, then making a Roth contribution and paying taxes on a lower rate when you make the contribution may be the wiser move. 

One reason you might be facing higher taxes in retirement comes from the “ticking tax bomb” that is those hefty balances in your tax-deferred 401(k) and IRA accounts. But don’t get down on yourself. For a lot of your working career, a Roth 401(k) was probably not even available.  In 2011, only 40% of 401(k) plans had a Roth option. Making sizable or even maxing out contributions to your employer’s pension plan is a great strategy. For now, keep contributing as long as you are able, only make sure the money is going into a Roth, if you have the choice.

There are other reasons that the future may bring higher tax rates for you in retirement. None are under your control, but all could impact you. The death of your spouse will result in a lower standard deduction or maybe a reduced itemized deduction, bumping you into a higher tax bracket. Also, don’t forget that with the expiration of The Tax Cuts and Jobs Act in 2025, you will be paying taxes at the higher 2017 rates, and depending on the 2024 election maybe even sooner. Inheriting investments or income-producing property in your retirement could cause an appreciable rise in taxable income, pushing you into a higher tax bracket.   


Enter Roth Conversions: Defusing Your Ticking Tax Bomb

Returning to circumstances you have the ability to control, let’s consider your traditional IRA. Suppose the bulk of your retirement assets resides there. You know or maybe your accountant has shown you that you will be in a higher tax bracket at the start of RMDs than you are currently.  If you could pay tax on the distributions you will be required to take in retirement at your current lower tax rate, you could save serious money. This is exactly what Roth conversions allow you to do. 

Roth conversions involve taking a distribution from your IRA which will be taxed at ordinary rates, like earned income. These distributions are then immediately “converted” from a traditional IRA to a Roth IRA. 

The funds in your Roth IRA will never be taxed again, including all that tax-free buildup, that additional income your account earns. That is a tremendous benefit that is widely underappreciated! Remember that RMDs from your traditional IRA include both your contribution and accumulated earnings.  Both parts are taxed at distribution. 


Why should I Make a Roth Conversion?

The only time you should voluntarily shell out more in taxes is when you KNOW your current tax rate is lower than it will be when you must take distributions. Period. 

Yes, a down market could mean the funds in your traditional IRA are worth less, so the tax to convert would also be less, but if your current tax rate is higher than you anticipate in retirement, you could still be paying more tax than you need to. 


When would a Roth Conversion be a bad idea?

Even if you know your taxes in retirement will be less than your current rate, there are a number of reasons you might want to hold off on Roth Conversions:

  • If you have to tap funds already invested or, even worse, borrow money to pay the extra tax, you’ll end up losing money. 
  • Funds converted to a Roth are subject to a five-year holding period. If they are withdrawn prior to five years they will be subject to a 10% penalty. 
  • The size of the Roth conversion you are considering might push you into a higher tax bracket. This doesn’t necessarily mean it’s a bad idea, but in this case, too much of a good thing would be bad. Postpone converting some of those funds to another year. 
  • If you have reason to think you will have a limited life expectancy, then paying the taxes now when you wouldn’t be paying them later doesn’t make sense.


Roth Conversions: Amount and Timing

The reason to make Roth Conversions is to reduce RMDs in retirement that would push you into a higher tax bracket than you would otherwise be in without them. To know whether this makes sense for you, you will need to know your tax bracket at retirement.  To figure that out, you will need to estimate your taxable income from a variety of sources that may include

  1. Social Security (likely 85%, if your “combined gross income from all sources” which includes Social Security, earned income, interest, dividends, and RMDs exceeds $32,000
  2. Dividends and Capital Gains from taxable accounts
  3. Deferred compensation
  4. Part-time income in retirement
  5. Interest on savings
  6. Passive income from rental properties you own, royalties, or partnerships
  7. Tax-deferred income like RMDs and annuities


To calculate your pre-Roth conversion RMDs, start with the estimated value for your IRA at retirement. Your investment advisor can suggest a reasonable rate of return based on your portfolio. Then factor in the impact of expected long-term inflation to get the long-term real return on your traditional IRA.  With the estimated value at retirement, find a copy of the Uniform Lifetime Tables from the IRS.  Calculate your expected RMD by multiplying the value of your account by the percentage of your RMD at the age at which you plan to start taking distributions.  

Your accountant has the expertise and software to forecast your taxable income (and RMDs if you want help) through your retirement years and beyond.  You will benefit from their advice when it comes to knowing how much and when to make conversions.  It is also their duty to advise you of the impact of possible unintended negative consequences.   


Potential Drawbacks of Roth IRA Conversions

Roth IRA conversions can be complicated. If you have buyer’s remorse, it can’t be undone. It’s best to know beforehand the potential downside of a conversion that is ill-timed or too big.

Remember that Roth IRA Conversions will increase your adjusted gross income (AGI) and your tax liability when you make them.  Here are some other possible negative downstream effects in the year you make the conversions:

  1. Higher taxes on your Social Security
  2. Decrease in deductible medical costs as the 7.5% exclusion of AGI increases 
  3. Impacting financial aid eligibility
  4. Change in eligibility for the Qualified Business Income Deduction
  5. Liability for the 3.8% Net Investment Income Tax (NIIT)


And as if that list weren’t enough, did you know that your costs for Medicare are based on your modified adjusted gross income (MAGI) from two years previous? You will need to plan for a higher premium for Medicare Parts B and D if the Roth Conversion you took jumped you into the next income bracket.  For some people, this is reason enough to consider completing Roth conversions before turning 63.


Recap: What to Know About Roth IRA Conversions and Your Taxes

When you consider Roth IRA conversions and your taxes, remember that you do not have to convert all your traditional retirement assets into a Roth account, and you might be better off leaving some as tax-deferred.  

Having some taxable income could be a good thing to take advantage of itemizable deductions like large medical bills. If you are charitably inclined, Qualified Charitable Deductions (QCDs) of up to $100,000 can be made directly from your deductible IRA contributions, reducing your taxable income.  

How much and when you decide to make the conversions are extremely important decisions. The more income sources you have in play, the more upfront planning you need. Roth IRA conversions can be complicated. It is important to have a team of professional advisors on your side when implementing these sophisticated transactions.  


We at Diamond & Associates are here to help you determine a tax savvy strategy that balances present day needs and future retirement goals. 


Let’s work together to help you live a great today and a better tomorrow.

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