What is Roth Conversion? And Does it Apply to You This Year?

When it comes to expenses in retirement, can you guess what your biggest expense is going to be?

Will it be on something fun like travel? Or spoiling your grandkids through countless Amazon packages?

Or what about healthcare and medical costs?

Believe it or not, taxes will be your single largest retirement expense, according to a study conducted by FINRA.

Why is this?

Well, if you are like most people, we tend to focus on paying as little as possible in taxes today. Right? Think about it.

Would you rather your CPA tell you that you owe more in taxes each year or less? Less, right?

Would you rather have a bigger paycheck today or a smaller one? Bigger, right?

The problem when it comes to taxes is we can’t see the forest through the trees.

By focusing on getting a bigger refund today, we end up unknowingly reducing our future retirement dollars. And fewer retirement dollars means less money to enjoy in retirement.

A Roth conversion can be an excellent way to improve your tax situation and pay less in taxes over the course of your lifetime.

Throughout this article, we’ll explore what a Roth conversion is, identify opportunities for when to do a Roth conversion, how to handle taxes on a Roth conversion, and lastly, the mechanics of a Roth conversion.

What is a Roth Conversion?

Let’s imagine for a moment, that you find yourself in a position where you’re approaching retirement and most of your retirement money is in a pre-tax 401k or Traditional IRA.

While you were working, your 401k account appeared to have worked great… and to your advantage. Benefits included contributions that are tax-deductible, a potential company match, and your money growing tax-deferred for decades.

But now, as you approach retirement, you suddenly realize that Uncle Sam and the IRS have been investing alongside you the entire time and now want their fair share of your money.

Every dollar you take out from your Rollover IRA or 401k in retirement will be taxed as ordinary income. Worse, even if you do not need the money, by age 72, you will be forced to take out a mandatory minimum percentage of your account each year, and this amount gets bigger each year. This is known as Required Minimum Distributions or RMDs.

So while that 401k seemed like a great idea 30 years ago, it is now turning into a giant tax bill in your future.

How do you save yourself from a giant tax headache? Enter stage left, the Roth conversion.

The reason this conversion has become so popular is that moving your money into a Roth IRA, allows for your money to grow tax-free and more importantly, your withdrawals also become tax-free in retirement.

Furthermore, Roth conversions are allowed for anyone, regardless of income! That’s right, there are no income limits on Roth conversions and you do not have to have earned income to implement this strategy. Roth conversions can occur while you’re still working or once you’re retired.

When Does a Roth Conversion Make Sense?

I can already see the wheels spinning now as you may be thinking to yourself, “Tax-free income sure sounds great, but why would I decide to pay more in taxes today?”

And the answer to that question is, “It depends.”

Each case and situation is going to be different and you’ll need to do the math to see if paying taxes today makes financial sense to benefit you in the long run.

Remember, the whole point of a Roth conversion is to lower your lifetime tax bill, not your taxes this year or next. This decision is entirely forward-looking and requires you to be able to identify when you might be in a good situation to take advantage of a lower tax year.

Helpful Pointer #1: Right now, the decision to do a Roth conversion has become even more appealing due to the Tax Cuts and Jobs Act of 2017. This legislation temporarily lowered taxes for 10 years and is set to revert back to 2017 tax rates by 2026. If no tax legislation is passed within the next few years to revise this ruling, future tax rates are on track to not only be higher but the tax brackets also will be smaller too.

So, with tax rates expected to increase within the next few years, it may make sense to consider a Roth conversion today.

A Roth conversion may make sense for you if:

You find yourself in a low-income year, either because:
* You or your spouse lost your job or you decided to scale back and work less.
You recently retired and now have less income than in previous years.
You retired but have not yet started collecting your Pension or Social Security.
You have retired and haven’t started taking Required Minimum Distributions (RMDs).
You find yourself in the 22% or 24% tax bracket today and believe tax rates will be higher in the future.
You have a sizable amount in cash that you can use to pay for the taxes on the conversion.
You have no need for your retirement assets and wish to pass your investments to your beneficiaries tax-free.
Your spouse died, and you’re still able to file taxes jointly this year.

Alternatively, a Roth IRA conversion may not be a good idea if:

You will be in a much lower tax bracket in retirement than you are today.
You unnecessarily push yourself into a much higher tax bracket because of the amount you convert.
You have no cash set aside to pay for the conversion, forcing you to deplete valuable investment assets to pay the taxes owed.
You waited too long and are now required to take out Required Minimum Distributions, thus increasing your income.
- Note: RMDs cannot be converted. You must first satisfy your RMD and then complete a Roth conversion.

As you can see, the decision of whether to do a Roth conversion is not always an easy one to spot.

Important Factors to Consider
When Deciding How Much to Convert

When determining the optimal amount of pre-tax assets to convert into a Roth IRA, we want to first start by identifying an amount that would “fill up” a specific tax bracket. This method is referred to as “Bracket Filling”.

Bracket filling occurs when you look at your Taxable Income and see how much “room” you have left in that particular tax bracket before going on to the next tax bracket.

Determining an ideal amount to convert into a Roth is not an easy task. In addition to considering tax brackets, your decision should also take into account the following:

Know the Brass Tax - Look at your income (post-conversion) to see what marginal and effective tax rates you’ll be in, so that you do not unnecessarily push yourself into a higher tax bracket.
Timing - How long is the window where you’ll have a lower income? This could be due to:
A time period before sources like Social Security, part-time work, or RMDs will play a role, and potentially bump you into a higher tax bracket.
Taxation of Benefits - Will the decision to do a Roth conversion negatively impact the future taxation of your Social Security benefits and/or trigger IRMAA on your Medicare premiums?
Future Tax Rates - Nobody can predict the future but it’s often assumed that taxes will continue to increase, however, what if that doesn’t happen? The decision to intentionally pay taxes at a lower rate today is a hedge against higher future taxes.
Volatile Markets - When your retirement account balance is down and lower than in the prior years due to poor market performance, you now have less to convert. Additionally, you can now allow your recently converted assets to recover in an account that will grow tax-free.

How to Determine Taxes on a Roth Conversion

The one downside to a Roth Conversion is, you guessed it … taxes.

Moving pre-tax money from a tax-deferred account creates ordinary income and is a taxable event. Thus, taxes are due on the amount you decide to convert and in the year of conversion.

Helpful Pointer # 2: It is a myth and common misconception that a pay raise, or in this case, a Roth conversion, will automatically push all of our income entirely into a higher tax bracket and therefore your take-home pay will decrease because of this new tax bracket.

Instead, the US Tax System is a progressive tax system, which means, only the amount above the new tax bracket is taxed at that higher rate.

Take a look brackets below and you can see that your first $20,550 (Married Filing Joint) of Income is taxed at 10% and the next dollar earned above $20,551 will be taxed at 12%; and so on and so forth.

Let’s Try an Example

George and Hillary are both 60 years old and make $170,000 combined.
They have no other sources of income and will take the Standard Deduction in 2022 of $25,900.
With a Taxable Income of $144,100, they are squarely in the 22% tax bracket (MFJ).
They have approx. $1,000,000 in their IRAs and $300,000 in a Taxable brokerage account.
They wish to incrementally begin doing Roth conversions today before retirement.

For 2022, they would like to do a Roth Conversion up to the top of their 22% tax bracket.
Once retired, they plan to delay Social Security and stretch Roth conversions over 5 additional years.

In the case of George and Hillary, converting $30,000 this year will cost them an additional $6,600 in taxes. Following the conversion, the $30,000 is placed into a Roth IRA and can now grow tax-free.

Now that we’ve learned about the upfront tax portion of the Roth conversion, next, we’ll dive into the long-term benefits once the conversion has had years, or even decades to grow.

Though the $30,000 converted is a relatively small amount compared to their $1,000,000 of IRA assets, breaking Roth conversions down into bite-size pieces is an effective strategy and also a hedge against future tax rates.

Second, incrementally doing Roth conversions today while working, puts George and Hillary in a good position to have to convert less pre-tax money in the future once they’re retired and no longer have income. Consistently filling up the 22% tax bracket from Ages 60-65, will allow them to convert $150,000+ before retirement.

Long-Term Benefits of Roth IRA Conversions

George and Hillary will retire at age 65 and have chosen to delay taking Social Security until age 70.

If you recall from earlier, they have $1,000,000 in retirement assets and $300,000 in a Taxable Brokerage account. Their only retirement income will be Social Security at age 70 of approximately $2,500/mo for each. And they desire to spend a moderate amount of $7,500 per month in retirement, adjusted for inflation.

As you can see in the illustration below, for most couples in retirement, their tax rates are typically very low in the first few years. And those who have intentionally chosen to delay Social Security may have no other income at all, resulting in a 0% tax bracket.

In the case of Geroge and Hillary, this gap in income between retirement (Age 65) and when Social Security begins (Age 70) presents a significant opportunity to take advantage of lower tax brackets and do a Roth conversion. Doing so would reduce their future amount of income that otherwise would be taxed at a higher bracket.

Many retirees today may be looking at the early years of the above chart and celebrating their low tax rate. But this celebration may be a bit too premature, because, if no action is taken, such as a Roth Conversion, their tax rate is about to unknowingly increase dramatically and a great opportunity will have been wasted.

In order to curb taxes in retirement, George and Hilliary will begin by filling up the 12% tax bracket through Roth conversions.

Though this decision will initially increase the amount of taxes George and Hillary will pay, you can see in the chart below, that their future tax rate will be significantly reduced in their later years. The decision to do a Roth conversion will take years, or even decades to fully materialize before the benefits fully kick in.

But, as your assets continue to grow tax-free, and by reducing your future RMDs, the cumulative benefits begin to show.

In the case of Geoge and Hilliary, their Roth conversion up to the 12% tax bracket, reduced their total tax bill by over $440,000 and dropped their average tax rate down by almost 6%.

How Do I Pay for The Taxes?
Should I Withhold Any Taxes?

When converting a Roth IRA, it’s generally best to not withhold any taxes if you have money in savings to pay for the taxes due upon the conversion. Why?

By electing to use some of your investible assets (instead of cash) to pay for the conversion, you are further eroding your retirement nest egg and future purchasing power.

However, if you find yourself in a position where you do not have sufficient assets in cash to cover the taxes, then you may want to consider either electing to reduce the size of your Roth conversion or withhold money and pay for the conversion using your retirement assets.

If you can, try your best to save ahead of time, to be able to pay for the conversion in cash.

Helpful Pointer #3: After you’ve completed your Roth conversion, don’t forget to make your estimated tax payments to avoid any underpayment penalties.

Mechanics of a Roth Conversion

The time has now come for you to facilitate the actual conversion of your pre-tax assets into your Roth IRA. You have the amount you’d like to convert and know approximately how much this conversion will cost in additional taxes. Now the question becomes, how do you actually do the conversion?

The good news is that this transaction is frequently requested and most brokerage institutions will have representatives available to walk you through each step. Additionally, most firms allow you to do a Roth conversion online or fill out a form.

When it comes time to move your investment positions between accounts, it’s generally preferred to move entire investment positions instead of selling and going to cash. This way, you’re able to remain invested, rather than be out of the market.

Beware of IRMAA

One area of caution when it comes to Roth conversions is that all withdrawals from your IRA, including those for a Roth conversion, will increase your taxable income and impact your Medicare premiums. This is especially important because an increase in Medicare premiums means a reduction in the amount you receive in Social Security benefits.

Income Related Monthly Adjustment Amounts (otherwise known as IRMAA) is determined by reviewing your income from your tax returns two years prior. This means that for your 2024 Medicare premiums, your 2022 income tax return will be used.

If your income has risen above a certain threshold (see chart below) due to the Roth conversion, you will receive notice from the Social Security Administration to inform you that IRMAA will be applied to your Medicare premium, and you will be required to pay the higher Medicare premiums for one year.

IRMAA is re-evaluated every year as your income changes, so it’s not a permanent change. And when your income comes down in the following year (2023), your IRMAA will also come down automatically.

Final Thoughts

Implementing a Roth IRA conversion can be an effective way to reduce your lifetime taxes and keep more of your hard-earned money.

Like with most things, when it comes to deciding on how much to convert and when, the answer is, “it depends.”

With today’s historically low tax rates and tax rates set to rise in 2026 unless legislation is passed, it may be a better time more than ever to review your situation and consult with your retirement and tax professional to see where a Roth conversion could benefit your situation.

Disclaimer: The views and opinions expressed are made as of the date of publication and are subject to change over time. The content of this website is for informational or educational purposes only. Website content is not intended as individualized investment advice, or as tax, accounting, or legal advice. It is not intended to be a recommendation or endorsement to buy or sell the specific investment. This information should not be relied upon as the sole factor in an investment-making decision. Website users are encouraged to consult with professional financial, accounting, tax, or legal advisers to address their specific needs and circumstances.