Should You Consider a Roth IRA Conversion?

If you're wondering if you should pay taxes early through a Roth IRA conversion—especially when that means shrinking your investment amount initially—you’re not alone. After all, conventional wisdom says to defer taxes as long as possible. But for many savers, particularly those with large traditional IRAs, Roth conversions can be a valuable strategy. Let’s break it down.

Why Consider a Roth Conversion?

The decision hinges on one key factor: tax rates. Specifically, it’s about the tax rate on your Roth conversion now versus the tax rate when you withdraw those funds later. This is sometimes referred to as tax arbitrage. If your current tax rate is lower than your future rate, converting makes sense. By paying taxes now, you avoid paying a potentially higher rate on withdrawals in retirement. If your current rate is the same as your future rate, the outcome is often neutral. Paying taxes upfront doesn’t inherently cost you more in the long run.

Addressing Opportunity Cost

Some people worry about the “opportunity cost” of using funds to pay the conversion tax—thinking those dollars could otherwise grow if invested. But if tax rates remain the same now and later, this isn’t an issue. Here’s why:

While you pay taxes earlier with a Roth conversion, you pay a smaller amount compared to the deferred taxes that would grow alongside your traditional IRA’s investments.
The earlier taxation with a Roth IRA may actually shield you from higher total taxes on a growing balance in the future.

Scenarios Where Conversions Make Sense

Roth IRA conversions require some educated guessing about the future, but in certain situations, they’re often advantageous:

Moving to a Lower-Tax State: If you plan to relocate from a high-tax to a low- or no-tax state, converting before the move can reduce your overall tax bill.
Avoiding the “Widow’s Penalty”: When one spouse passes away, the surviving spouse often moves to a higher single-filer tax bracket. Converting before this happens can save on future taxes.
Your Heirs Will Pay Tax on Your Traditional IRA at a High Rate: Your heirs will be forced to withdraw your inherited IRA over 10 years. This can result in your heirs (if they are in their peak earning years) paying tax at a higher rate than you would.

The Five-Year Rule Simplified

A common concern is the Roth IRA’s five-year rule, which confuses many savers. Let’s clarify:

If you’re 59½ or older and already have a Roth IRA open for five years: There’s no waiting period for tax-free withdrawals of converted funds or earnings.
If you’re 59½ or older and don’t yet have a Roth IRA: Converted funds can be withdrawn tax-free, but earnings are taxable for the first five years (though no 10% penalty applies).
For heirs: If you pass away before the five years are up, your heirs will still benefit from tax-free withdrawals after the remaining time in the five-year window passes.

Special Cases to Consider

Charitable Givers: If you plan to leave your traditional IRA to charities, don’t convert. Traditional IRAs offer tax benefits when donated directly to charity, avoiding all taxes. A Roth conversion would unnecessarily reduce the amount left for the charity.
Medicare IRMAA Surcharges: If you’re doing partial Roth conversions, be mindful of the income brackets for Medicare surcharges. Exceeding these thresholds—even by a dollar—can result in significantly higher costs.

Final Thoughts

Roth IRA conversions aren’t one-size-fits-all, but they can be a powerful tool for managing your tax liability and maximizing your retirement savings. The key is understanding your current tax situation, anticipating future rates, and carefully planning around your specific circumstances.

If you’re considering a conversion, we invite you to give us a call to help evaluate your unique situation and ensure your strategy aligns with your long-term financial goals.