Converting a traditional Individual Retirement Account to a Roth IRA offers tax advantages in certain situations. It is most advantageous when you can pay any resulting income taxes without using funds from the traditional IRA.

Contributions to Roth IRAs have already been taxed, so they grow tax-free. That means withdrawing from a Roth IRA after age 59 ½ won’t add to your taxable income. Unlike a traditional IRA, you can keep contributing to a Roth at any age, and there are no age-based distribution requirements. You can keep saving and earning tax-free as long as you like. 

If you will be in a higher tax bracket in retirement, a Roth IRA can be a helpful tax-planning tool. 

However, if you decided to take advantage of this tool by rolling tax-deferred dollars from a traditional IRA fund into a Roth, the converted funds count as income. You will owe federal and state taxes on those funds in the year you make the conversion. 

To make the traditional IRA to Roth conversion pay off, it’s best to pay those taxes with money from outside the IRA. Depending on the amounts involved, the conversion can push you into a higher tax bracket, so you may be facing a significant tax bill. 

Paying federal and state taxes out of the IRA means that you’ll have less to invest in the Roth. If you’re in a high tax bracket, you could give up a third or more of your retirement savings and the tax-free gains you would earn on that money in the future. That loss may outweigh the tax benefits of the Roth conversion—especially if your time horizon to retirement is short. 

And if the conversion occurs in your peak earning years and lands you in the top tax bracket, the marginal tax rate on those funds may be more than you avoided by deferring the IRA contributions from your income in the first place. Paying the taxes from a separate source helps avoid the risk of undoing the tax advantages of careful retirement savings.  

Timing is key when considering conversion and potential Roth IRA taxes. It may be several years before taxes paid upfront in the conversion are offset by the tax savings. In addition, funds must be held in the Roth IRA for five years to be disbursed tax-free. Withdrawing from a Roth IRA early or before age 59 ½ will incur a 10 percent penalty. 

That said, if you have the cash in hand to pay the resulting taxes, conversion may pay off, especially if you will retire in a high tax bracket or a high-tax state. Conversions can be spread out over multiple years to ease the tax burden and may be offset by deductions such as charitable contributions. We can help you run calculations based on your exact circumstances to determine whether a conversion will benefit you. Contact us today to schedule a consultation! 

—  Toni Shears