Editorial Note: Forbes may earn a commission on sales made from partner links on this page, but that doesn’t affect our editors’ opinions or evaluations.
The $11 trillion that Americans have saved up in traditional individual retirement accounts (IRAs) is something of a mirage.
“I tell clients with money in traditional IRAs not to get too in love with their balances, as it’s not theirs just yet,” says Greg Hammer, founder of a wealth advisory firm in Schererville, Ind. “I have to remind them that they, or their spouse or their kids, are going to owe income tax on that money.”
A Roth IRA conversion, in which you transfer money from a traditional IRA into a Roth IRA, can be a smart way to manage your tax bill. But there are a bunch of moving pieces you need to get a grip on before doing a Roth conversion.
What Is a Roth IRA Conversion?
At first glance, a Roth IRA conversion is exactly what it sounds like: You move your retirement savings from a traditional IRA to a Roth account. This effectively allows you to prepay your tax bill sooner rather than later.
All money you convert will benefit from the advantages Roth IRAs provide, like tax-free growth. No matter how much your Roth IRA increases in value, you won’t owe a cent of taxes in retirement. Between now and then, though, you’ll be able to withdraw all the money you convert without penalty or taxes, as long as it’s been at least five years since you converted it.
You’ll also avoid pesky mandatory minimum withdrawals, called required minimum distributions (RMDs), once you turn age 72. That helps your money keep growing for even longer.
“Clients always look at me and ask why they should spend $25,000 today to convert a $100,000 traditional IRA,” says Hammer. “And I ask them if they want to pay the tax now, or let that money keep growing and owe RMDs on a bigger balance years from now.”
Advantages of a Roth IRA Conversion
Once you convert retirement savings to a Roth IRA, you give yourself more ways to manage your tax bill in retirement, including:
• Free yourself from RMDs. If you have money in a traditional IRA, you must begin RMD withdrawals once you turn 72. Doesn’t matter if you need the money or not. The IRS insists on the withdrawal so it can collect income tax on every dollar withdrawn. Converting to a Roth IRA lets you avoid this, which allows you to leave every penny growing to your heirs, if you so choose.
• Money you withdraw from a Roth IRA can be tax free. The money you convert (and pay tax on) can be withdrawn without you needing to pay income tax at any time and any age. But—there’s seemingly always a but with tax law—if you are younger than 59 ½ when you convert, you need to wait five years to avoid a 10% early withdrawal penalty. This applies separately to each conversion you make. So if you do a Roth conversion two times, each in different years, you will have two five-year clocks to run out. In addition, there’s another five-year rule to keep in mind: Your account must have been funded at least five years ago to qualify for tax-free withdrawals of earnings. This applies regardless of your age.
• Smaller RMDs on your remaining traditional retirement accounts. You don’t have to convert all the money in a traditional IRA to a Roth IRA. Partial Roth conversions are often the tax-wise move (more on this later). Whatever amount you do convert before you turn 72 leaves less money behind in your traditional IRA, which effectively means less money you’ll have to take as RMDs later.
• Less taxable income can reduce other retirement expenses. When you are locked into RMDs, those withdrawals count as taxable income. Reducing your RMD burden means less taxable income in retirement, and that can help you control other retirement costs. Your Medicare Part B premium and whether you owe tax on Social Security benefits—and how much—are based on taxable income.
• A hedge against your tax rate not being lower in retirement. If you expect your annual income from retirement sources—RMDs from traditional accounts, Social Security and perhaps a pension—won’t be appreciably lower than your current income, that reduces the likelihood you would be in a lower tax rate later on. That might increase the appeal of converting now, paying the tax and then having future growth tax-free. And though there is absolutely no way to predict what tax rates will be when you retire, let alone five, 10 and 20 years into retirement, having some retirement savings immune from the possibility of higher tax rates is worth considering.
• Easier on your heirs. Just about anyone other than a spouse who inherits an IRA will have to empty the account within 10 years after the year you pass. If it’s a big traditional IRA, that can create tax headaches for them. They will still need to withdraw all money in an inherited Roth IRA in 10 years, but they will not owe tax—and it won’t impact their taxable income level.
Disadvantages of a Roth Conversion
• You expect your income to be much lower in retirement. If you are in a high tax bracket today, paying the tax on a Roth IRA conversion might not make sense.
• You don’t have the cash to cover the tax bill. You don’t want to use money from the Roth IRA conversion to pay the tax. The goal should be to keep that money growing tax-free for as long as possible. Nor should you make a Roth IRA conversion a priority if you have high-rate credit card debt, or you would need to dip into your emergency fund.
• You plan on moving to a lower-tax state. “If you currently live in a state where the conversion will be taxed, and you plan on moving to a state that doesn’t tax retirement income, it may make sense to wait until you have moved,” says Brian Kennedy, president of KCA Wealth Management in Camp Hill, Penn.
• You expect your family will be applying for college financial aid. Money inside a retirement account does not impact financial aid. But the year you convert, the conversion amount will show up on your tax return as income. That could impact your family’s financial aid package.
How to Do a Roth IRA Conversion
The easiest way to do a Roth conversion is when both accounts are at the same financial institution. If you don’t yet have a Roth IRA, but like the financial institution that houses your traditional IRA account, you can open a Roth IRA and then proceed with a conversion, typically with just a few mouse clicks.
If you want to convert a traditional IRA at Brokerage A to a Roth IRA at Brokerage B, there are a few steps involved. First, you need to open the Roth IRA at Brokerage B. Then tell Brokerage A you want to make a trustee-to-trustee direct rollover to Brokerage B and note how much of your account balance you’d like to move.
In both scenarios, the brokerage firm where you park your converted Roth IRA will file a 1099-R with the IRS to report the taxable distribution. And when you file your federal tax return for the year you will also be required to report the distribution on Form 8606.
You can also take a distribution from your traditional IRA as a check and then send the money yourself to your new Roth account. But that’s asking for trouble. If your self-managed rollover doesn’t get done within 60 days the entire amount is treated as a taxable distribution. Granted, you would have paid tax on it anyway when you convert it, but if you are under 59 ½ years old when you miss the 60-day window, you will also be slapped with a 10% early withdrawal penalty.
How to Manage Roth IRA Conversion Taxes
Given all the moving pieces, working with a tax pro, or financial advisor who has serious chops understanding all the moving pieces, is well worth considering.
You likely will want to consider a strategy that limits your conversion in any given year to a sum that won’t bump you into a higher tax bracket. If you retire before 72 and have lower income, those years can be a sweet spot for converting traditional IRA money to a Roth.
If you work with a financial advisor, you can also discuss ways to offset the tax due on the conversion. Harvesting losses on investment accounts is one possibility. And if you itemize your federal tax return, you might want to consider front loading more charitable giving—which qualifies as a tax deduction—into a tax year when you will have more taxable income from a Roth IRA conversion.
When Does a Roth IRA Conversion Make Sense?
Converting money from a traditional IRA to a Roth IRA can help you manage your tax bill in retirement better as well as position you to leave an easier financial legacy to your heirs.
When to convert—and how much to convert in a given year—must be carefully thought through as the conversion will raise your taxable income for that year. If you’re considering a Roth IRA conversion, consulting a financial advisor or tax pro with experience in Roth IRA conversions can be the best move.