Roth Conversions: What You Need to Know

When opening a retirement savings account, you’re typically presented with the option of choosing between a traditional account or a Roth account. While you may have used a traditional account for the initial tax savings, it’s also important to build the tax-free retirement income offered by Roth accounts. Making the switch from a traditional account to a Roth account is called a Roth conversion.

Should you consider taking advantage of this opportunity? We’re discussing what you need to know below. 

Traditional Versus Roth

A traditional account is created using pre-tax dollars, meaning that although you weren't taxed on the dollars going in, the distributions you take out in retirement will be taxed (just like income). 

A Roth account is created using after-tax dollars, meaning that you were taxed on the dollars going in but the distributions you take out in retirement are tax-free (because the tax has already been paid on the contribution). Additionally, a Roth can be an appealing option because it does not include a required minimum distribution age. This means that you can continue to grow tax-free dollars for the remainder of your life. 

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 some or all of your traditional account into a Roth account.

Consideration #1: Your Timeline

If you plan to use the money within the next few years, you may want to forego a Roth conversion. Why? Because the money you convert into a Roth should stay in the Roth for a five-year holding period. If withdraws are made before the five years are 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 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. A Roth conversion creates additional income the moment you make the switch from a traditional account to a Roth account. You need to be prepared to pay the taxes on this additional income. While it’s possible to cover the tax bill using a portion of the distribution itself, this is typically not advised for two reasons: you’d be robbing your future retirement of income and you may be subject to a 10 percent penalty for taking the funds. That is why We suggest paying the taxes owed with non-retirement account 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.

In addition, consider how government policy will change tax rates. Certain tax brackets exist today but can be changed at any time by Congress. 

Consideration #4: How Much to Convert and When

Making sure that you're not unintentionally pushed into a higher tax bracket is a key consideration when performing a Roth conversion. 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 Roth Conversion

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

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

Being able to withdraw income tax-free in retirement is an appealing option for many. And it’s good to know that while you may have chosen to open a traditional account years ago that you have the option to convert it at any time. Before making any moves, make sure to speak with a trusted financial professional. Together, you can go over these important considerations and how they interact with your unique financial situation.