By Dr. Jim Dahle, WCI Founder

The process of doing a Roth conversion is not particularly complicated. What CAN be complicated is the decision about whether to do one and how much to convert.

How to Do a Roth Conversion

Step 1: Transfer money from your traditional IRA to a Roth IRA.

Step 2: Pay taxes on that money.

That’s really all there is to it. Simple, no? There are a few variations. For example, you can transfer money directly from a 401(k) to a Roth IRA (and then pay taxes). You can also, if the plan allows it, transfer money from a 401(k) to a Roth 401(k) or a 403(b) to a Roth 403(b) (and then pay taxes).

Benefits of a Roth Conversion

There are several benefits of a Roth conversion.

1. That money will never be taxed again (although estate or inheritance taxes could apply).
2. No Required Minimum Distributions on that money (not true in a Roth 401(k) or 403(b)).
3. If left to heirs, no income taxes for them either (better to inherit a Roth IRA than a traditional IRA).
4. Assuming you’re using a taxable account to pay the taxes, you are getting more money, on an after-tax basis, into tax-protected and asset-protected accounts. In essence, you’re transferring money from taxable to tax-protected.
5. Done properly, you may be lowering your overall lifetime tax burden.
6. Smaller RMDs after age 73 (or 75 after 2033).
7. May reduce estate/inheritance taxes by removing “the government’s portion” of retirement accounts from the estate.

The Downside of a Roth Conversion

There is really only one downside of a Roth conversion

1. You pay taxes on it.

Did you get that? This isn’t like a Backdoor Roth, where you’re comparing a taxable account to a Roth account. The Roth account always wins in that scenario. In this scenario, the Roth DOES NOT always win. In fact, it can be a pretty complicated decision.

More information here:

Roth Conversions and Contributions: 10 Principles to Understand

When to Do a Roth Conversion

The idea behind a successful Roth conversion is that you want to prepay taxes at a lower rate than you would pay them later. Sometimes, there is another benefit, such as the ability to do a Backdoor Roth IRA going forward (this occurs in situations where you cannot roll a SEP-IRA or traditional IRA into a 401(k) of some type).

When are good times to do a Roth conversion of tax-deferred assets?

1. As a student, resident, or upon residency graduation.
2. During a sabbatical or other low-income year.
3. While temporarily disabled (assuming disability income is tax-free).
4. While in the military.
5. After cutting back to part-time.
6. In early retirement, before receiving Social Security.
7. When you have a particularly low Roth-to-tax-deferred ratio and desire more tax diversification.

Basically, any time it would make sense to make Roth 401(k) contributions, it probably makes sense to do Roth conversions.

When are bad times to do Roth conversions?

1. During peak earnings years (not always, especially for supersavers and those expecting to be in the top tax brackets in retirement).
2. When you are converting money you would give to charity anyway.
3. Using money you would give to heirs who are in a low tax bracket.
4. When you don’t have taxable money you can use to pay the taxes (not always; in fact, this only slightly decreases the value of a Roth conversion),
5. When you don’t have much of a tax-deferred account.

Remember that in retirement, especially early retirement, you want to have enough taxable (i.e. tax-deferred account withdrawals) income to fill the 0%, 10%, and 12% brackets. So, it’s usually silly to convert anywhere near ALL your tax-deferred money to Roth money.

More information here:

Why Wealthy Charitable People Should Not Do Roth Conversions

How Much Should I Convert?

The general rule is that you convert up to the top of a certain tax bracket. That might be the 12% bracket or perhaps even the 22% bracket. Generally doing conversions above this amount isn’t advised, unless you expect a great deal of taxable income in retirement (and would be paying 24%+ on retirement income). Practically speaking, what does that mean?

Consider this example.

Dr. Jones is 55 years old, and they have $2 million in tax-deferred assets, $700,000 in taxable accounts, and no Roth accounts. They have cut back to part-time, and now they make $80,000 per year. This year, they will begin maxing out a Roth 401(k) and personal and spousal Backdoor Roth IRAs. Their spouse does not work, and they will be taking the $29,200 standard deduction now [2024]. They think a Roth conversion is a good idea, but they are unsure how large of a conversion to do this year.

Let’s assume the tax-deferred assets grow from $2 million to $2.5 million at the time of retirement. Let’s also assume that between Dr. Jones and their spouse, they’ll get $50,000 a year in Social Security, 85% of which will be taxable. Assuming the $29,200 standard deduction, their taxable retirement income will be around $117,000, squarely in the 22% bracket. Thus, it probably does NOT make sense to pay taxes at more than 22% now to do a Roth conversion. Twenty-two percent makes sense for their situation (no Roth and plenty of taxable to pay the taxes), and 12% is a great deal.

Their current taxable income of $50,800 is well within the 12% bracket. The first $43,500 they do in Roth conversions this year will be done at 12% to fill up the 12% bracket. That much is a no-brainer. They could also convert another $106,000 (filling the entire 22% bracket) this year as well. That conversion will cost them ($43,500 × 0.12) + ($106,750 × 0.22) = $28,705 in taxes. They can certainly afford that, given the size of their taxable account.

Between the Roth 401(k) contributions, Backdoor Roth IRA contributions, and Roth conversions (and probably spending some of the taxable money), they will rapidly be converting taxable assets to Roth assets, a great financial move. If they do this sort of thing five years in a row or so, they will have pretty nice tax diversification throughout retirement due to a sizable Roth account.

In short, Roth conversions can be a great tool, but run the numbers first. Roth does NOT always win this competition.

Want a second opinion on your own tax diversification plan for retirement? Hire one of our Recommended Financial Advisors offering good advice at a fair price.

What do you think? Have you done a Roth conversion? Why or why not? Do you anticipate doing some in the future? Comment below!