How a Roth conversion worksA Roth conversion is the process of shifting assets from pre-tax accounts to Roth accounts. Pre-tax accounts include traditional IRAs, pre-tax assets in 401(k) plans, and other savings vehicles. Because those funds have never been taxed, you'll have to pay income tax when you take distributions from pre-tax accounts. However, by converting to Roth, you can get the payment out of the way earlier and create an after-tax pool of money.
Potential benefits of converting
So, why would you pay taxes today when you can wait until later? That's a topic to evaluate carefully with a CPA or professional tax advisor. When the circumstances are right, there are several potential benefits to prepaying your taxes. The primary benefit is having a source of tax-free income in retirement (assuming you meet all IRS requirements when you take distributions).
Know how much you can spend: It's easier to understand and predict how much you have available for spending when you have after-tax assets. By contrast, with pre-tax accounts, you'll need to reserve funds—or find money from a different source—to pay taxes that result from distributions.
Dodge rising tax rates: There's no way to predict what will happen with income tax rates. But if you believe that rates will be higher in the future, you can pay now, at today's rates. Just be aware that the tax system could change in a variety of ways. Higher income tax rates aren't the only path to higher revenues for the U.S. government —so this approach could backfire.
Skip RMDs: With pre-tax accounts, you generally must take required minimum distributions (RMDs) after age 72. That's not the case with Roth holdings. If you'd prefer to leave your retirement savings intact as long as possible, converting pre-tax assets to Roth can help you do so.
When it makes the most sense to convert
It's hard to time anything perfectly, but several opportunities may arise that help you minimize the tax burden from converting.
Low-income periods: During years when you earn a relatively low income, you might be in a lower tax bracket than usual. For example, you or your spouse may be starting a career, going back to school, spending time in between jobs, or starting a business. Converting during those years may be less costly than converting in high-earning years.
Business losses: Business owners may be able to use net operating losses (NOLs) from current or previous years to offset the impact of a Roth conversion. Speak with your tax advisor to discuss the details of this strategy.
Market losses: If your investments have lost value, there may be a silver lining. The assets you convert will be worth less than they were before, so the tax calculation on the amount converted should be smaller.
How to convert
Before making a decision, discuss the pros and cons with a tax professional.
When you convert to Roth, you'll generally need to pay taxes on those pre-tax dollars and gains from the traditional account. In most cases, it makes sense to pay those taxes using assets that are outside of the account you're converting. If you pay the taxes with funds from the account you convert, that tax payment may be considered a “distribution," resulting in additional tax liability.
If you decide that converting to Roth is right for you, ask your financial advisor how to complete the conversion. The process is often as simple as filling out a request form.