May 11, 2020

Edited 05/28/20

Roth Conversion: Pros and Cons

When should you consider a Roth conversion in retirement?

If you’re saving for retirement, you have lots of tax-deferred options to choose from but few that allow you to withdraw your earnings tax-free. You could open a Roth IRA, but they have relatively low contribution limits, and if your income exceeds the established limits, you won’t be eligible to contribute to one.

But there is another way you can take advantage of tax-free withdrawals in retirement, and that’s by completing a Roth conversion. According to some advisors, Roth conversions are an all-weather strategy where they continue to grow tax-free and if you convert today, you will be paying less in taxes. In 2020, this strategy may be even more effective if you have retirement accounts that have a loss or find yourself in a lower tax bracket than you expect in the future.

What Is a Roth Conversion

There are no income limits restricting who can complete one and you have the potential to convert much more than $6,000 or $7,000 a year, which are the current Roth IRA maximums, depending on your age. To complete the conversion, you move money from a tax-deferred account such as a 401(k), 403(b) or traditional IRA into a Roth account where you can withdraw your money tax-free. 

While there’s a lot to like about Roth conversions, there are a few things you need to watch out for.

Pros of a Roth Conversion

These are some of the biggest benefits of a Roth conversion.

  • Tax-free withdrawals. Since you pay taxes on Roth contributions upfront, you can withdraw your original contributions at any time without paying additional taxes. And you can withdraw your earnings tax-free as long as you’re 59½ or older and the account has been open for at least five years.  
  • Reduced tax burden for heirs. The SECURE Act eliminated what is known as a stretch IRA, which allowed people who inherited IRAs to make withdrawals throughout their lifetime. Under the new law, non-spousal heirs must draw down the entire account within 10 years, which could significantly increase the amount of taxes they have to pay. Completing a Roth conversion and paying taxes on the money now could significantly reduce the amount of taxes your heirs have to pay. 
  • No minimum distributions required. Unlike other types of retirement accounts that require you to take minimum distributions beginning at age 72, you never have to take a required minimum distribution from a Roth. This allows your money to grow tax-free for as long as you want.
  • Tax diversification. A popular argument for contributing to tax-deferred accounts like 401(k)s, 403(b)s and traditional IRAs is that you’ll be in a lower tax bracket during retirement because you’ll be earning less. But the truth is unless you’re retiring tomorrow you don’t know what your tax bill will look like when you retire. Plus, income taxes are currently at historically low rates, so it’s possible that you might end up paying more in taxes during retirement than you do now. A Roth conversion can help you diversify your accounts, so you don’t have too many that are receiving the same tax treatment. 
  • No time restrictions on contributions. You can contribute to a Roth for as long as you want, even during retirement as long as you have earned income.
  • It can be completed in phases. You don’t have to convert an entire account to a Roth at one time. You can convert as much or as little as you want, and you can do it in stages. In fact, it may be advantageous to do it in phases. That way you can convert an amount that allows you to stay in your current tax bracket without pushing you into the next.

Cons of a Roth Conversion

If you’re thinking about converting your money, here are some of the potential drawbacks you should be aware of.

  • The tax bill. Since you can only contribute after-tax dollars to a Roth account, you must pay taxes on the amount you convert at your current tax rate. Depending on how much money is in your account, you could face a hefty bill. It’s also important to understand that if you’re converting an account with contributions that were non-deductible, you only need to pay taxes on the contributions you deducted. It gets complicated, so be sure to work with your accountant and investment advisor to determine the appropriate amount of taxes you need to pay.
  • Potentially higher taxes. When you complete a Roth conversion, you pay taxes at your current rate. Depending on your income and what the tax rate is when you retire, you may pay more in taxes now than you would if you kept the money in tax-deferred accounts and paid taxes when you withdrew it in retirement. Plus, depending on how much money you convert, you might end up in a higher tax bracket for the year you complete the conversion, increasing your tax bill even further.
  • Paying the tax bill. Speaking of your tax bill. You have to come up with the cash to pay it. If you don’t have enough money in liquid accounts to cover the bill, you may be tempted to pay it using money from the account you’re converting. But that may not be a good idea. Every dollar you use from your account to pay taxes now reduces your earning potential for retirement. 
  • Waiting period. You must wait at least five years after the conversion to withdraw your earnings without paying taxes or a penalty even if you’re already 59½. If you’re in or nearing retirement and think you’ll need to access the money in less than five years, converting is probably not the best option. Note: You can withdraw your original contributions at any time. 
  • It’s irreversible. When you complete a Roth conversion, there’s no way to put that money back into a tax-deferred account. So, it’s important to make sure it’s the right decision before you begin.

Completing a Roth conversion will have many tax implications—both today and in retirement. If you’re considering converting some of your tax-deferred accounts, it’s best to evaluate your personal situation and financial goals for the future.