What are Roth conversions? 

As investors strive to optimize their retirement savings and minimize tax burdens, understanding how Roth conversions benefit them becomes more important. Roth conversions have great significance when it comes to personal finance, especially when it comes to retirement planning.  

So, what exactly is a Roth conversion? A Roth conversion is simply the process of moving funds from traditional retirement accounts, such as a 401(k) or a traditional IRA, into a Roth IRA.  

As simple as it sounds, this can be a strategic financial maneuver that promises a few highly desirable long-term benefits.  For one, a well-timed and executed Roth conversion can provide investors with tax-free withdrawals during retirement. The caveat is that doing a Roth conversion (or conversions) needs careful consideration of various factors, including tax implications and individual financial goals. 

In this article, InvestmentNews tackles questions on Roth conversions such as how do Roth conversions work, how are Roth conversions taxed, and other related topics.  

Introduction to Roth conversions 

In the realm of retirement savings plans, Roth conversions are among the newest tools in an investors’ toolbox. These are processes where investors convert to a Roth Individual Retirement Account from a traditional IRA or 401(k) plan.  

Named after Senator William Roth of Delaware, the Roth IRA was introduced to the American public in 1998 as another retirement savings vehicle. This was followed by the Roth 401(k) in 2006.  

Traditional IRA vs Roth IRA 

Before delving deeper into Roth conversions, what are the differences between a traditional IRA and a Roth IRA? The table below highlights their important differences.  

Traditional 401(k) vs Roth 401(k) 

As for traditional 401(k) and Roth 401(k) plans, what are their main differences? Traditional 401(k) plans are tax-deferred retirement accounts, which means they are funded with pre-tax money and distributions are taxed after retirement.  

Meanwhile, Roth 401(k) plans are funded with after-tax money, and retirees don’t pay taxes on distributions or withdrawals. The table below shows their marked differences:  

Types of Roth conversions 

Investors should remember that there are four common types of Roth conversions, namely:  

• transferring or converting funds from a traditional IRA to a Roth IRA 
• rolling funds over from a traditional 401(k) to a Roth IRA 
• transferring funds from a traditional 401(k) to a Roth 401(k) 
• using the Backdoor IRA strategy 

Why do a Roth conversion? 

There are a few compelling reasons to advise your client to do a Roth conversion, such as:  

• tax-free withdrawals 
• penalty-free withdrawals  
• tax-free earnings 
• having the ability to withdraw contributions at any time 
• no required minimum distributions (RMDs) 
• account owners can leave tax-free money to heirs 

For withdrawals to be deemed tax- and penalty-free, they must be qualified distributions. This simply means the withdrawals/distributions adhere to the five-year rule and the account owner is at least 59½ at the time they make the withdrawals.  

What is the five-year rule? 

Under the five-year rule, a Roth IRA account must exist for at least five years for withdrawals or distributions to be tax- and penalty-free.  

While contributions to the Roth can be withdrawn anytime without penalty, the earnings cannot be withdrawn without incurring a 10% early withdrawal penalty and/or income tax. To be free of taxes or penalties, the Roth account must be around for five years since it got its first contribution.  

Read our article on the five-year rule to find out more.  

Important note: the five-year rule applies to beneficiaries 

In the case of an inherited Roth IRA, its beneficiaries are obliged to take RMDs. They do not have to pay any taxes on withdrawals from an inherited Roth IRA if the original owner held the account for five years or more.  

The 10% penalty that applies to Roth IRA withdrawals before age 59½ doesn’t apply to inherited Roth IRAs.  

But remember, there are rules for taking RMDs, and these depend on when the original account owner died and the type of beneficiary: 

• spousal beneficiary: can stretch out RMDs throughout their life expectancy 
• non-spousal beneficiaries: may have to withdraw the entire account balance within 10 years if the original account owner passed away in 2020 or later 

When is a good time to do a Roth conversion? 

Due to the tax-free withdrawals that your client can get down the line, it may seem like any time is a good time to do a Roth conversion. But there are certain situations when it’s best to do Roth conversions. They are:  

1. When the stock market is in a downturn.  

If your client has some stock investments in their traditional IRA or 401(k) that are decreasing in value, then that would be a good time to transfer them to a Roth. As their value goes down, the conversion tax also decreases.  

For example, let’s assume your client has 10 shares of an ETF each worth $200 in a traditional IRA. If they converted it to a Roth, the taxes on the dollar value of the shares would be $2,000.  

If the portfolio declined by 20%, they could transfer those 10 shares and pay $1,600 in taxes. Once these stocks are converted, they’ll continue to grow tax-free in the Roth account until they’re withdrawn in retirement. 

3. They expect the government to raise taxes in the future. 

If you or your client think that the government will raise taxes in certain situations (such as rising inflation), a Roth conversion can cushion the impact of higher future taxes. Put your client in touch with a tax advisor for accurate guidance in this area. 

If your client has a substantial amount of money in their traditional IRA, doing a conversion can benefit them. Once they convert, the money they have will be subject to a one-time tax bill for the Roth conversion. Apart from that, they won’t have to take any RMDs during retirement. Any withdrawals they make by the time they are 59½ will be tax-free.  

Could the next few years be the best Roth conversion years? 

According to finance expert Ed Slott, the years before 2026 are excellent times to convert to Roth IRAs. In this video, he claims that income taxes are at an all-time low, so converting now will incur a smaller tax bill. Watch the video for more insights:  

4. Your client plans to move to a state with higher income taxes.  

If part of your client’s retirement plans is to move to another state and incidentally, it’s a state with higher income taxes, then a Roth conversion is warranted.  

5. Your client wants to leave money for their heirs or beneficiaries.  

A Roth conversion is advisable if: 

• your client has enough money saved in other retirement accounts, and 
• they don’t intend to fund their retirement with their 401(k) plans or IRAs 

This way, the money in the Roth IRA can grow tax-free and their beneficiaries can withdraw the money without paying taxes. However, there are different guidelines for certain types of beneficiaries to follow.  

6. Your client’s gross income disqualifies them from contributing to their traditional IRA.  

If your client’s income is so high that they become disqualified from contributing to their IRAs, then a Roth conversion is advisable.  

To bypass these limits, your client can set up a traditional IRA, make a non-deductible contribution to it, then convert that to a Roth IRA. This is commonly known as a backdoor Roth IRA.  

When should you not do a Roth conversion? 

As advantageous a Roth conversion may be, there are situations when a Roth conversion is not advisable. Here are some instances when your client should not do a Roth conversion:  

• They are getting Affordable Care Act (ACA) subsidies while on a healthcare plan. In this situation, Roth conversions will increase their income and reduce their subsidies. 
• They are at least 63 years old and are paying Medicare premiums. Roth conversions can increase the cost of premiums. 
• They have a low income and are receiving Social Security benefits. Doing a Roth IRA conversion can subject a larger portion of their Social Security money to tax.  
• They need the money within a five-year period. Doing a Roth conversion and taking money from the account will break the five-year rule and result in additional penalties.   
• They don’t have a separate source of funds to pay for the resulting conversion taxes. Taking money from the converted funds may deprive them of potentially high earnings apart from higher taxes.  

Is there a limit to the number of Roth conversions you can do? 

Fortunately, no, there is no limit. Your client can do as many Roth conversions as they need. It’s not required to convert all the assets; your client can convert a small portion at a time. 

A wise strategy would be to spread several smaller Roth conversions over a longer period to avoid landing on a higher tax bracket and minimize conversion taxes. Remember also that timing can be very important to maximize your client’s Roth conversions.   

Do Roth conversions count as contributions? 

No, Roth conversions are not considered as contributions. Roth conversions and Roth contributions have distinct tax rules and require separate forms when filing them for income tax purposes. 

When you convert a traditional IRA or traditional 401(k), money from a pre-taxed source goes into the Roth account. The taxes are due on the conversion. On the other hand, a Roth contribution means that after-tax money from a checking or savings account goes into the Roth. Taxes have already been paid and so the after-tax money grows tax- and penalty-free in the Roth retirement account.  

At first glance, Roth conversions may seem to be little more than the process of taking money from a traditional 401(k) or IRA then converting it to a Roth IRA. You can even enlist a financial institution to do the process.  

In the capable hands of a savvy investor or financial advisor, Roth conversions are an indispensable tool for retirement, estate, and tax planning. The most effective way to leverage Roth conversions is to take your clients’ financial goals and budget. From there, figure out the optimal combination of conversion amounts and conversion times to minimize the taxes.  

Read up on Roth conversions and browse other retirement topics right here on InvestmentNews!