When you contributed to your retirement plan, the first question you faced was: Traditional, or Roth? The difference in these has to do with when you get the tax savings. Traditional retirement accounts save you money up front on taxes, but you'll have to pay the piper when you withdraw that money in retirement. Roth accounts don't help you at all right now, but during retirement you won't have to pay a dime of taxes on the withdrawals.

Most people use traditional retirement accounts for the immediate tax savings. But if you have a low income year, or if you retire early, you can CONVERT your traditional account to a Roth. This allows you to pay the taxes during a year when you're in a low tax bracket. Should you consider taking advantage of this opportunity? Like all financial planning questions, the answer is: It depends.

What Is a Roth Conversion?

A Roth conversion refers to the act of converting a traditional IRA account into a Roth IRA account. A traditional IRA account is created using pre-tax dollars, meaning the distributions you take from a traditional IRA account in retirement is taxable income. A Roth IRA is created using after-tax dollars, meaning the distributions you take from a Roth IRA account in retirement is tax-free (because the tax has already been paid).  

Additionally, a Roth IRA can be an appealing option for some because it does not have required minimum distributions. This means that you can continue to save and grow tax-free dollars for the remainder of your life. If you plan to leave some of your retirement money to your heirs, a Roth IRA is better than a Traditional IRA: it can save them a lot of money on taxes.

Considerations to Make Before Doing a Roth Conversion

While a Roth conversion could be a great option for some, it could be a costly mistake for others. That’s why we’ve outlined four important considerations to make before converting your traditional IRA into a Roth account.

Consideration #1: Your Timeline to Retirement

If you’re retiring within the next few years, you may want to forego a Roth conversion, or only convert part of the money. Why? Because the money you convert into a Roth IRA must stay there for a five-year holding period. If withdraws are made before the five years is up, you could be hit with a 10 percent penalty and/or additional income taxes. 

Consideration #2: Tax Obligations

When considering a Roth conversion, you simply can’t ignore the tax implications associated with this move. While your aim may be tax-free income in retirement, you will have to pay taxes on that income at some point. You need to be prepared to pay the taxes on this additional income, which could very well push you up into a higher tax bracket now. And you don't want to pay the taxes on your Roth conversion using the money in your retirement account: you’d be robbing your future retirement of income (defeating half the purpose of a Roth conversion) and you may be subject to a 10 percent penalty for taking the funds. 

Consideration #3: Your Future Tax Bracket

One of the main reasons an individual chooses to do a Roth conversion is for the advantage of tax-free withdrawals in retirement. With that in mind, you’ll want to take into consideration whether your tax bracket will be higher or lower in the future when you anticipate withdrawing the funds. If you believe you’ll be in a lower tax bracket come retirement, it may be worth waiting to withdraw the funds then. On the other hand, if you’ve experienced a year of interrupted or lowered income (lost a job, missed out on a bonus, etc.), you may be in a lower tax bracket now than you would when entering retirement.

Consideration #4: How Much to Convert and When

If you’re on the cusp of a higher tax bracket, but still want to do a Roth conversion, you do have the option to convert a portion at a time. By spreading the conversion across several years (as opposed to one lump sum), you can lower your yearly tax obligation. 

How to Make a Conversion Happen

The IRS offers three possible ways for an individual to convert funds from a traditional IRA into a Roth IRA account. These methods include: 

• Rollover: You are given the funds and must put the funds into a Roth IRA account within 60 days. 
• Trustee-to-trustee transfer: The institution currently housing your traditional IRA transfers the distribution to a different institution where it'll be held in a Roth IRA. 
• Same trustee transfer: The institution currently housing your traditional IRA may also be able to house your Roth IRA, and they roll the account over for you.¹

How We Use Roth Conversions

We normally use Roth conversions during the years between retirement and RMD age - they can be especially helpful if you retire early. If you don't need to use your portfolio withdrawals completely, we'll always want to "fill up" the lower tax brackets with partial Roth conversions so you can lock in a low tax rate on that money. Want to learn more? Send us a secure message here and we'll get back to you within a day or two: