Roth IRA conversion pros and cons: Is this tax strategy right for you?

A Roth IRA conversion can be a powerful tax-planning strategy, allowing you to move money from a traditional IRA or other pre-tax retirement account into a Roth IRA. In exchange for paying taxes on the converted amount today, you may be able to enjoy tax-free withdrawals in retirement and potentially reduce future required minimum distributions.

But the benefits of a Roth IRA conversion don't come without tradeoffs. The additional taxable income can push you into a higher tax bracket, increase Medicare premiums or create other unintended consequences depending on your financial situation. That's why understanding the pros and cons of Roth conversion is an important step before making a move.

So, is a Roth IRA conversion right for you? The answer depends on factors such as your current and future tax rates, retirement timeline, available cash to cover taxes and long-term goals. Before converting retirement savings to a Roth IRA, it's important to weigh the potential benefits and drawbacks in the context of your overall financial plan.

What is a Roth IRA?

A Roth IRA is a retirement account where you contribute after-tax dollars to your plan. When converting a pre-taxed account like a traditional IRA, 401(k), SEP or SIMPLE IRA to a Roth IRA from a tax-deferred account, income tax also must be paid on funds being transferred or converted. Because you’ve already paid taxes on these contributions, the Roth IRA distributions are tax-free after a five-year holding period and provided you are over age 59 1/2.

Also, there are no Required Minimum Distributions for original Roth IRA holders (versus named beneficiaries), making Roth conversions appear attractive relative to a tax-deferred retirement account, where you face RMDs and must pay income tax on future withdrawals.

Pros of Roth IRA conversion

Tax-free withdrawals: Since you’ve already paid taxes on your contributions, withdrawals from a Roth IRA are tax-free after meeting certain conditions.

No Required Minimum Distributions: Original Roth IRA holders are not required to take RMDs, unlike traditional IRA holders.

Potential for lower taxes in retirement: If you expect to be in a higher tax bracket in retirement, converting to a Roth IRA now could save you money in the long run.

Cons of Roth IRA conversion

Immediate tax liability: Taxes on funds transferred from a tax-deferred account to a Roth could be substantial, so you want to temper the tax liability as much as you can.

Potential for higher tax bracket: The amount of funds you’re converting could bump you into a higher tax bracket if they're all transferred in the same year.

Impact on Medicare premiums: Higher income from a Roth conversion can increase your Medicare premiums.

Factors to consider before a Roth IRA conversion

Roth IRA conversions require the right tax conditions

Taxes on funds transferred from a tax-deferred account to a Roth IRA can be substantial, so it’s important to manage the tax liability as carefully as possible.

A Roth IRA conversion is often most beneficial when your income and marginal tax rate are lower. The goal is to determine whether the long-term benefits of tax-free withdrawals may outweigh the upfront tax cost.

This can create a narrow window of opportunity for a Roth conversion. Early retirees with low or no earned income can be good candidates, especially if they haven’t yet started collecting Social Security benefits.

Income levels and timing

There may be other life stages when you move into a lower income tax bracket. Even then, the amount you convert could push you into a higher tax bracket if the funds are transferred all at once. In some cases, it may make sense to spread Roth conversions over multiple years to help manage the tax impact.

A multiyear conversion strategy may also help prevent higher Medicare premiums, which can increase once your income exceeds certain thresholds. During the conversion process, work with a tax professional and a financial advisor to help manage potential tax liabilities. That may include coordinating the timing of other taxable events, such as the sale of a home.

Roth conversions may also reduce future RMDs from traditional retirement accounts. Depending on your age and situation, that may give you additional years to spread conversions over time before RMDs begin.

Longevity and financial goals

In addition to the time required to complete the conversion itself, the converted assets may need years to grow before the benefits outweigh the taxes paid upfront.

Life expectancy and long-term financial goals are also important considerations. In general, the longer the money remains invested in the Roth IRA, the more opportunity it has to potentially benefit from tax-free growth.

Before converting retirement savings to a Roth IRA, consider how the strategy fits into your overall retirement income plan, expected time horizon and legacy goals.

How to pay taxes on a Roth IRA conversion

Before worrying about recouping the taxes triggered by a Roth conversion, you need to have a plan for paying the taxes themselves.

We generally advise against using funds from your retirement accounts to pay the taxes, as that could leave you with less retirement income in the long run. If you use money from retirement accounts to pay the taxes (including possible penalties on the tax withholding if you’re under age 59 1/2), you won’t benefit from any future investment growth that money may have generated.

Given the amount of savings that may be required to pay for a Roth IRA conversion, this requirement itself may be a deal breaker. At the very least, it may mean a conversion doesn’t provide a large enough advantage to justify the upfront tax cost.

Don’t forget the other criteria for a Roth conversion, such as managing your tax liabilities, avoiding unintended effects on Medicare premiums and having enough time for the converted assets to potentially benefit from tax-free growth. In general, you shouldn't need the converted funds for at least five years, and perhaps much longer to recoup the impact of the taxes paid upfront.

Backdoor Roth IRA strategies for high earners

If you’re considering a Roth conversion in your 50s or older, when your income may be near its peak, does that mean a Roth conversion isn’t right for you?

Not necessarily. For some high-income earners, converting after-tax 401(k) assets to a Roth IRA can be an effective way to build tax-free retirement savings, provided their employer's plan allows it.

Companies are increasingly offering after-tax 401(k) contributions in addition to traditional 401(k) and Roth 401(k) options. Like a Roth account, you pay income taxes upfront on contributions made to an after-tax 401(k). While you can withdraw your after-tax contributions tax-free, any investment earnings are generally taxable when withdrawn.

An after-tax 401(k) may also provide a path to a Roth conversion. If your employer's plan permits it, you may be able to transfer after-tax contributions to a Roth IRA/Roth 401k while still employed without triggering taxes on the contributions themselves. There are some employers that make this process as low friction as possible with automated in-plan Roth rollovers that avoid creating taxable earnings.

It's also important to remember that many high-income earners may benefit from maximizing traditional 401(k) contributions first, since those contributions can reduce taxable income in the year they're made.

If you’re considering this strategy, review your 401(k) plan’s distribution provisions and consult with both a tax professional and a financial advisor to determine whether it makes sense for your situation.