By Ryan Muscatella, CFP®, APMA® and Ryan Oliver, CFP®, NSSA®

In recent years, you may have heard the buzz around the term Roth conversions and wondered, “What exactly are Roth conversions, and do they make sense for me and my family?” As is often the case with matters concerning financial planning and investment management, the answer is usually the same: it depends.  

What is a Roth conversion?  

First, let’s define what exactly a Roth conversion is. A Roth conversion is when you move assets from a tax-deferred retirement plan, such as a traditional IRA (Individual Retirement Account), SEP IRA, SIMPLE IRA, 401k, 403b, Thrift Savings Plan (TSP) etc., to a Roth IRA, which enjoys tax-free growth and withdrawals (given that you meet all of the withdrawal requirements).  

Assets moved from tax-deferred retirement plans to a Roth IRA are considered taxable income in the year of the conversion, meaning you will owe income tax on the dollar amount you convert to a Roth IRA.

Why have Roth conversions received so much attention over these past couple of years? 

The SECURE Act, which was passed in late 2019, introduced changes that impact non-spousal beneficiaries inheriting a traditional IRA or qualified retirement plan post 2019. Under these new rules, beneficiaries are no longer able to “stretch” required minimum distributions (RMDs) over the course of their lifetime. Instead, the entire account must be paid out on or before December 31st of the tenth calendar year following the death of the IRA owner, otherwise known as the “10-Year Rule.”  

Additionally, if the original IRA owner was taking RMDs, the beneficiary owner would be required to take RMDs as well, and the 10-year rule would also still apply. As of April 2024, however, the IRS, for the fifth straight year, has waived this rule that requires beneficiary owners to maintain RMDs on inherited IRA accounts.  

These changes have increased the popularity of adding money to a Roth IRA via direct contributions or Roth conversions. Investors are drawn to the tax-free growth and withdrawals that a Roth IRA offers, as well as the potential flexibility it offers their heirs, who would not be subject to taxes on withdrawals from an inherited Roth IRA and would not have the burden of annual RMDs.  

Roth conversions may seem like an obvious benefit because of potential tax savings, however, it’s essential to remember that Roth conversions are a tax timing strategy, not a tax avoidance strategy.  

By opting for a Roth conversion, you are simply choosing to pay taxes now versus paying them in the future. If you or your beneficiaries expect to be in a higher tax bracket later in life or to have lower taxable income in a specific year, it may make sense to convert funds from a tax-deferred retirement account to a Roth IRA sooner rather than later to take advantage of potential tax savings. 

Is a Roth conversion right for me? 

There are many considerations and assumptions that need to be made before determining if a Roth conversion makes sense for you. A Roth conversion essentially boils down to the investor’s comfort level with paying taxes now to potentially reduce tax payments in the future.  

The key considerations that investors should think about before proceeding with a Roth conversion are outlined below. By evaluating these factors, you can determine if a Roth conversion might align with your unique financial situation and goals. 

Paying for the Tax You Will Owe

When considering a Roth conversion, the optimal way to pay the conversion tax is with funds from outside the retirement account. This means utilizing cash on hand or money from an investment account, like a taxable brokerage account. Using these sources, especially if they keep the full value of the converted amount intact, allows the entire amount to continue growing tax-free. If you withhold taxes from the retirement account and the full amount is not converted over into a Roth IRA, it may diminish the benefit of doing a conversion in the first place, leaving you in a similar position had you not converted the funds. 

Required Minimum Distributions (RMDs)

Implementing a Roth conversion strategy before required minimum distributions become mandatory can be advantageous for investors with significant pre-tax IRA or retirement plan balances. Choosing to convert assets to a Roth account prior to RMDs will decrease the pre-tax IRA value, potentially lowering anticipated RMD amounts and enhancing the portfolio’s tax efficiency.

While reduced RMDs and tax-free withdrawals are positive aspects of a Roth conversion, it is important to remember that the converted funds will increase the investor’s income now, potentially pushing the taxpayer into a higher tax bracket. Moving into a higher tax bracket may lead to reduced deductible medical expenses, higher taxable social security, and higher Medicare Premiums, also referred to as IRMAA (Income-Related Monthly Adjustment Amount). The repercussions of being in a higher tax bracket are temporary, however, since the conversion amount is only considered taxable income in the year you do the conversion. You will have to weigh whether the potential long-term savings are worth the temporary tax repercussions. If you are less inclined to increase your current tax bill and would prefer to let your traditional IRA continue to grow, then Roth conversions might not be the best choice.  

Legacy Planning 

For those prioritizing wealth transfer to heirs, Roth accounts often prove superior to traditional IRAs. This is because taxes on Roth conversions paid up front will be removed from the family’s taxable estate and beneficiaries will not owe tax on future Roth account withdrawals. Additionally, children inheriting Roth IRAs, who tend to be the most common noneligible designated beneficiary, are exempt from annual RMDs, and depending on who the beneficiary is, the account can continue to grow tax-deferred for up to 10 years after the original owner’s passing. Keep in mind, however, that paying taxes now, on behalf of your beneficiaries, may not be advantageous if you anticipate that your beneficiaries would not have as much taxable income as you do.

If your legacy planning involves charitable giving, there are some things to keep in mind when it comes to considering a Roth conversion. If you plan on using your IRA RMD to make Qualified Charitable Distributions (QCDs) or name a charity as the beneficiary of the IRA account, converting funds to a Roth IRA would be counterproductive. This is because QCDs help decrease your tax bill and charities are tax exempt from federal and state income taxes. It’s crucial to discuss your estate’s beneficiaries with your advisor before proceeding with Roth conversions to optimize your estate plan. 

Timing of Conversions

While we believe that timing the market is impractical and unpredictable, converting pre-tax funds to a Roth IRA when the account has experienced a decline in value can benefit long-term investors. For example, let’s say you have $50,000 in your traditional IRA, and during a market fluctuation those shares decrease in value to $40,000. If you execute a Roth conversion while your traditional IRA value is at $40,000, you are still converting the same number of shares but your tax burden for the conversion would only be for the $40,000 value as opposed to the $50,000 value. Although there is no guarantee that the funds will regain their value, if the market does recover, it means that your account is able to enjoy tax-free growth since distributions on Roth IRAs are not taxed.

When it comes to the timing of Roth conversions, it is also important to take into consideration the 5-year rule and the account owner’s life expectancy. The 5-year rule requires you to wait five years before withdrawing any converted balances, contributions, or earnings, regardless of your age, to avoid penalties. If the investor needs the funds prior to five years after the conversion or passes away before recouping the benefit of paying the taxes upfront, a Roth conversion may not be the most tax-efficient decision. 

Tax Law Changes

Building a financial plan would be easy if laws never changed, but we know that it is not realistic to assume that legislation will never change throughout one’s lifetime. Engaging in a Roth conversion strategy comes with the risk of potential changes in tax rates or how Roth IRAs are taxed. While potential future changes in laws shouldn’t dissuade you from formulating plans, understanding the dynamic nature of the tax landscape is crucial when making decisions about converting assets to a Roth IRA. 

Roth conversions can be a powerful tax planning strategy. However, as with any financial planning tactic, there are inherent risks to consider before deciding what is best for you and your financial goals. The role of a financial advisor is to identify and explain these risks, provide you with relevant information, and assist you in determining which risks are reasonable to accept given your unique circumstances. 

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If you are interested in pursuing a Roth conversion, whether now or in the future, we recommend reviewing the points mentioned above and reaching out to your financial advisor to further discuss available options. 

To learn more about Roth conversions, watch our webinar “Does a Roth Conversion Make Sense for You.” 

If you are not a Cassaday & Company client, we are happy to offer a complimentary, no-pressure evaluation of your current financial plan and goals. Please contact us at info@cassaday.com or (703) 506-8200. 

Disclosures: Although the information has been gathered from sources believed to be reliable, it cannot be guaranteed. Federal tax laws are complex and subject to change. This information is not intended to be a substitute for specific individualized tax or legal advice. Neither Osaic Wealth, Inc., nor its registered representatives, offer tax or legal advice. As with all matters of a tax or legal nature, you should consult with your tax or legal counsel for advice.