Nearly a quarter of U.S. households own a Roth IRA, yet they account for just 10% of the $13.6 trillion in total individual retirement arrangements assets, mostly funded by direct contributions. But Roth accounts can also be funded by conversion from a traditional tax-deferred IRA, an option that may not be as familiar to many taxpayers.
Also, higher income earners are locked out from direct Roth contributions, while conversions are not subject to income limits and can therefore offer a practical work-around. While not appropriate for everyone, a Roth conversion can be a very attractive tax saving and wealth building tool over a longer time horizon including into the next generation.
IRAs were first created in 1974 as part of the broader Employee Retirement and Income Security Act dealing with pensions and retirement accounts. The traditional IRA was created to accept tax-deductible contributions or to receive assets rolled over from other retirement plans but is subject to taxation as ordinary income upon withdrawal. IRAs are intended to be depleted during the account owner’s lifetime and are therefore subject to mandatory withdrawals in retirement. Then in 1997, a new and intriguing variant was introduced, called the Roth IRA account (originally tagged the “IRA Plus” but ultimately named for its chief sponsor, U.S. Sen. William Roth of Delaware).
Roth IRAs essentially flipped the script: They are after-tax accounts, meaning that contributions are not deductible. However, if certain conditions are met, all the investment earnings can be distributed completely tax-free, no matter how large they grow.
The attraction hardly ends there. Traditional IRA holders must begin taking taxable required distributions beginning in the year they reach age 73. Roth accounts are not subject to any required distributions during the owner’s lifetime. And unlike the traditional version, a Roth can be passed tax-free to the named beneficiaries of the owner, who then have 10 years to fully deplete the assets.
Obviously, the tax bill is the major consideration in deciding whether to convert. The amount of the conversion is reported as ordinary income on the account holder’s tax return and is therefore subject to taxation at the highest applicable rate and could push the owner into a higher marginal bracket. It is important to have the ability to cover the additional tax bill without tapping into the IRA, which would trigger additional tax and potentially a 10% penalty if the taxpayer is under the minimum age.
How does one evaluate conversion options? Here are a few considerations.
Tax bracket in retirement. Most of us assume we will be in a lower bracket once we quit working, but this may not necessarily be true. Social Security benefits, investment income and taxable distributions from traditional IRAs can combine to place the retiree into the next tax bracket. Furthermore, many people wish to continue working part-time beyond their official retirement. Also, tax rates are subject to legislative priorities of Congress. Addressing our unsustainable deficits and federal debt will require significant tax increases over time, which could make tax-free distributions in the future even more attractive.
Preempting required distributions. Some retirees who are financially able to delay Social Security after retirement may have an attractive window of opportunity. If they retire at 65 and wait until 70 for Social Security, they may temporarily find themselves in a relatively low tax bracket that affords the chance to convert some of their traditional IRA assets to a Roth before required distributions begin.
Partial conversions. IRA owners can choose to convert all or part of their tax-deferred assets. Taxpayers can estimate how much to convert each year up to the point of crossing into the next marginal tax bracket. For example, above $94,300 a married couple moves from a 12% tax rate to 22% on marginal income. If the couple earned $80,000 in 2024, it might make sense to convert $14,300 at the current 12% tax rate. Completing partial conversions each December is a means of gradually balancing exposure to taxable, tax-deferred and tax-free account structures to mitigate the rate risk in the future, a concept sometimes referred to as “tax diversification.”
Time is the magic element. After-tax assets growing over an extended period can produce startlingly large tax-free income thanks to compounding, dubbed the “eighth wonder of the world” by Albert Einstein. The earlier the conversion, the greater the benefit, especially if the account owner wishes to pass assets along to younger beneficiaries.
Many corporate and nonprofit retirement plans including 401(k), 403(b) and 457 plans now also offer a Roth contribution option as well as the traditional pre-tax option. Participants may also have the choice of moving funds from the traditional to the Roth side of the plan if the employer allows it. This so-called “in-plan conversion” works the same way as the IRA conversion, requiring the participant to pony up the tax on the amount converted.
Unlike contributions to Roth IRAs, which can be made until April 15 of the following year, Roth conversions must be completed before Dec. 31 to qualify for the current tax year, so there is still time to consult with your tax professional or advisor to assess your specific circumstances. Many investment companies like Schwab and Vanguard also offer Roth conversion calculators to assist in your evaluation. Just as in your portfolio, a wise investment in a conversion today could pay large dividends down the road.
Christopher A. Hopkins, CFA, is co-founder of Apogee Wealth Partners in Chattanooga.