Details Matter in Roth IRA Conversions

A Roth IRA conversion can be one of the most powerful tools in a long-term tax strategy—if done wisely. It involves transferring funds from a traditional IRA, 401(k) or other pre-tax retirement account into a Roth IRA. The money you move is treated as taxable income in the year of the conversion. Once in the Roth, those assets grow tax-free, and qualified withdrawals in retirement are also tax-free.

The trick is knowing when to do a conversion. Your financial advisor can work with you and your accountant to identify whether a conversion makes sense and, if so, to plot a strategy.

Timing: When You’re in a Low Tax Bracket

Because a Roth conversion means paying income tax now on the converted assets, the strategy makes most sense if your current tax bracket is likely lower than it will be during the bulk of your retirement years. This often happens:

• In early retirement, before Social Security benefits and/or required minimum distributions (RMDs) from retirement accounts begin 
• In a year of reduced income (e.g., after a job change, during a sabbatical, etc.) 

Sizing: “Filling Up” Your Marginal Tax Bracket

You may be able to convert a portion of your IRA without pushing yourself into the next bracket. Your financial advisor can work with you and your accountant to: 

• Know your current bracket: Check how much headroom you have before you cross into the next tax tier. 
• Project your future brackets: Estimate your retirement income from Social Security, pensions, investments, and RMDs. If your future income will be higher, converting now may save you taxes in the long run. 

The best strategy may be to convert in chunks. Rather than converting a large amount all at once, spread conversions over several years to avoid jumping from, for example, the 22% to the 24% tax brackets.

Stock Market Considerations

The state of the market can also influence the timing of a Roth conversion. A market downturn may be an especially favorable time for a Roth conversion, given that bear markets tend to recover fairly quickly, historically speaking. When your IRA balance is temporarily lower due to market losses, your current-year income taxes on the conversion amount will be smaller. Then, if the investments recover in the Roth IRA, all the gains will be tax-free.

The same logic applies to investments you may believe are poised for growth. Converting them before they increase significantly can shield future gains from taxation.

If you need to sell assets in your IRA to pay the conversion tax or cover living expenses, it may offset some of the benefits. It's usually better if you can pay the taxes from a separate cash account.

Other Strategic Considerations

Now we’ll get even further into the weeds. All of the following topics are ones your financial advisor can help you take into account:

• 10-Year Rule. If you inherit an IRA from someone (who isn't your spouse), most non-spouse beneficiaries must withdraw all the funds from the inherited IRA within 10 years of the original account holder’s death. If the value of your traditional IRA or other pre-tax retirement account is substantial and the number of non-spouse beneficiaries is minimal, lifetime Roth IRA conversions could be considered if the conversion rate falls into a lower bracket than the non-spouse beneficiaries will face during the 10-year withdrawal period. Please note you cannot directly convert from a non-spousal inherited IRA to a Roth IRA. There is an extra step your advisor can help you understand.
• Five-Year Rule. Each conversion has its own five-year holding period before you can withdraw the converted amount penalty-free (if you're under age 59½).
• Medicare Premiums. A large conversion may increase your income and, two years later, result in higher Medicare Part B premiums.
• State Taxes. Don’t forget that state income taxes may apply to the conversion amount. 
• Estate Planning. Roth IRAs aren’t subject to RMDs for the original account holder and can be an efficient tool for passing wealth to heirs income tax-free.

Final Thoughts

Roth IRA conversions can be a tax-savvy move, especially when executed during years of low income or down markets. But they’re not a one-size-fits-all solution. A well-planned conversion strategy should take into account your tax bracket now and in the future, your market outlook, and your broader financial goals.

Work with a tax advisor or financial planner to model different scenarios and develop a multi-year Roth conversion strategy tailored to your situation. A little planning can go a long way toward minimizing taxes and maximizing retirement income.