Key Takeaways:
- A Roth conversion moves money from a traditional account into a Roth, taxed now in exchange for tax-free growth and withdrawals later.
- Converting during a temporarily lower-income year, such as between jobs, can let you convert at a lower tax rate.
- A “conversion ladder” — converting smaller amounts over several years to stay within your current bracket — typically beats converting all at once.
- Converting in your peak earning years, or when it would push you into a higher bracket, often doesn’t make sense.
- Because Medicare Part B/D premiums are based on income from two years earlier, a large conversion can quietly raise your Medicare costs.
If you have money in a traditional IRA or 401(k), you’ve probably wondered how much of those savings will eventually go to taxes. A Roth conversion can help reduce future taxes and build a source of tax-free income, but you generally need to pay taxes now to get those benefits later. Here’s a breakdown of the factors at play in determining if this could be a smart move.
What Is a Roth Conversion?
A Roth conversion moves money from a traditional retirement account into a Roth account. You pay taxes on that money now, at today’s rates. In exchange, that money grows tax-free from then on, and you never pay taxes on it again, not even when you withdraw it. Roth IRAs also don’t require the owner to take required minimum distributions (RMDs). Tax-free growth sounds like the right idea, but it isn’t always the best move.
When a Roth Conversion Could Make Sense
A Roth conversion could be the right move when your income is temporarily lower than usual. For example, if you’ve had a slow income year or you’re between jobs, this could be an ideal time to convert some traditional retirement savings at a lower tax rate.
A conversion may also make sense if you expect tax rates to be higher in the future or want to reduce future RMDs. Having money in both traditional and Roth accounts can also give you more control over taxable income during retirement.
Should You Convert Everything at Once?
Converting a traditional IRA all at once could trigger a substantial tax bill and push you into a higher tax bracket. Instead, converting smaller amounts over several years is typically a better move.
A common strategy known as a “conversion ladder” is to convert enough each year to take advantage of your current tax bracket without unnecessarily pushing income into a higher one.
Work with a tax professional to figure out how much you can convert each year without risking a jump to a higher tax bracket.
When You Might Want to Skip a Roth Conversion
If you’re currently in your peak earning years and sitting in a high tax bracket, or if the conversion could push you into a higher tax bracket than your current one, it may not make sense.
Keep in mind that you’ll need to pay the tax bill. Ideally, this should come from savings outside your retirement account. If you use retirement funds to pay the taxes owed, you’ll put a dent in your investments, and you could incur additional tax consequences.
The Medicare Trap
If you are approaching or already enrolled in Medicare, something to keep in mind is that a Roth conversion can quietly raise your premiums.
Medicare Part B and Part D premiums are based on your income from two years earlier. A large Roth conversion adds to your taxable income, which can increase your Medicare premiums. This is exactly why smaller conversions spread over a few years tend to work better for people in or near retirement.
A Roth conversion can be one of the smartest pathways to create tax-free retirement income, but it can also be an expensive mistake if you do it at the wrong time or with the wrong amount. A tax professional can help you assess your income needs, goals, and timeline if you’re considering a conversion.
