Roth Conversion Basics: Benefits and Drawbacks

Taxes on retirement savings are inevitable—but the big question is when you pay them. With a Roth conversion, you move money from a tax-deferred retirement account into a Roth IRA. You’ll pay income taxes on the amount you convert, but once in the after-tax Roth account, it can grow and be withdrawn tax-free.

While it can be a smart way to reduce your tax bill in retirement, how can you know if a Roth conversion is right for you? In this article, we’ll explain the basics of converting your traditional account to a Roth status. This includes an overview of benefits, drawbacks, and how you can work with a financial advisor to understand if it fits your plans and goals.

What Is a Roth Conversion?

A Roth conversion involves shifting funds from a traditional retirement account (e.g., a 401(k), 403(b), or IRA) to a Roth IRA. This turns your savings from a pre-tax to an after-tax status, allowing future investment and compound interest growth and withdrawals to be tax-free.

During the conversion process, you must pay income taxes on the moved balance—whether it’s some or all of the money from the pre-tax account. By doing so, however, you can withdraw the funds without needing to pay taxes in retirement. As we’ll discuss further, this can be both a positive and a negative, as it means shouldering a potentially large amount of taxes in the short term, which could increase your tax rate.

You can perform a Roth conversion as many times as you want and with any amount, which can be beneficial as a strategy to reduce tax liability if done in smaller portions rather than a large sum. Converted funds must stay in the Roth IRA for at least five years before withdrawal, subject to a 10% penalty (except in certain circumstances, such as being 59.5 years old or meeting an exception). It’s important to note that once completed, Roth conversions are fixed and can’t be undone, a rule that has been in effect since 2018.

When to Consider a Roth Conversion

Though it’s not a one-size-fits-all solution, there are many reasons to consider a Roth conversion. For example, it allows you to avoid required minimum distributions (RMDs) in retirement, as these don’t apply to Roth IRAs. Another benefit is its use as an estate planning tool since it enables you to pass on tax-free money to your heirs, unlike a traditional account subject to income tax.

Here are five reasons a Roth conversion may be worth considering:

1. You Expect to Be in a Higher Tax Bracket Later

Converting to a Roth IRA is a good strategy if you believe your income and tax rate will increase. While contributing to a traditional retirement account may lower your taxable income today, it can mean facing more substantial taxes if you’re in a higher tax bracket upon retirement.

According to Christopher Leonard, advisor at Cornerstone Financial Services in Southfield, Michigan, a Roth conversion is beneficial for investors “in the early stages of their careers and anticipate being in a higher tax bracket during retirement” because it shifts “tax liability while in lower tax brackets.”

With a Roth conversion, you pay taxes on the balance you transfer now but get to withdraw tax-free savings and investment earnings later. As Leonard notes, this is particularly helpful if you’re a younger professional who may see pay increases, a business owner with growth potential or up-and-down income, or you think you may receive a windfall or inheritance ahead of retirement.

2. You Have Time to Let the Money Grow Tax-Free

A conversion becomes more valuable the longer your money can grow tax-free with compound interest in a Roth IRA. Since you’ve already paid the taxes on the converted amount, you won’t owe anything on what you eventually withdraw. In other words, the account balance will be yours to keep. If you have many years or decades before retirement or diverse income streams to bolster your income until you tap into the savings, this is a significant advantage.

An additional benefit is that Roth IRAs “have no required minimum distributions (RMDs), unlike Traditional IRA accounts” or 401(k)s “that require RMDs starting at age 73,” says Leonard. This gives you more flexibility on how long you can keep your funds in the account and when you withdraw. If you desire, you can delay taking money out for as long as you want, maximizing the time for your investments to grow.

3. You Can Pay the Conversion Taxes Without Using Retirement Funds

Per Leonard, “Taxes must be paid on any pre-tax investments that are converted during the Roth conversion.” However, an overlooked part of a Roth conversion is how you pay the taxes. You might assume they’ll just come right out of the retirement account you’re moving, but that’s not always the case, nor is it the best option.

If you have sufficient liquidity, you can use outside funds to pay the taxes when converting a traditional account to a Roth status. This keeps your retirement savings intact, allowing them to stay invested and continue earning interest without interruption.

It’s also important to note that there can be penalties for using the funds from your retirement account to pay the taxes. If you’re not yet at the minimum withdrawal age of 59.5, the IRS will treat it as an early distribution. Because of this, you’ll face a 10% early withdrawal penalty on top of the income tax, directly reducing your savings and growth potential.

4. You Want to Leave Tax-Free Money to Heirs

Roth conversions are also a powerful estate and legacy planning tactic because, as Leonard highlights, “Roth IRAs pass tax-free inheritances to heirs.” By converting now and paying the taxes yourself, you can pass on tax-free money to your beneficiaries, allowing them to realize the full benefit of your saving and investing efforts.

Kevin D. Quinn, J.D., president at Legacy Counsellors, PC, explains that “heirs pick up a significant income tax burden when inheriting” your traditional accounts. On the other hand, he says, “The Roth IRA is not taxed to your heirs and can grow income tax free after your death.”

Using a conversion as an estate planning move is viable if you don’t see yourself needing to access the money during retirement. For instance, if you have other income sources or retirement accounts with substantial savings, you can leave your Roth IRA in place—or perhaps put it in an irrevocable trust—as a dedicated part of your estate.

5. You Want More Flexibility in Retirement Income Planning

As you near retirement, how you withdraw your money becomes just as important as how much you save. Roth conversions can be an effective tool for creating tax diversification, letting you control your annual taxable income by utilizing accounts with different tax treatments.

If you currently hold much of your savings in traditional, tax-deferred accounts like a 401(k) or IRA, or you’re nearing the time to receive Social Security or take RMDs, converting some of these funds to a Roth IRA can give you a tax-free option to draw from. This can help you manage your income and reduce your tax burden in retirement.

Potential Drawbacks to Consider

A Roth conversion can be a good strategy—especially if you fit into some of the categories listed above—but it does have some notable pitfalls and isn’t the proper decision for everyone’s situation.

Perhaps the biggest issue is that it requires having cash upfront to pay the income taxes on the conversions. This can require you to dip into some of your short-term savings and could be a large number, which can be daunting—even if some of the benefits of a conversion sound good.

Another drawback is that you could end up in a higher tax bracket because of a conversion. This is because it will count as taxable income in the eyes of the IRS. Depending on the amount of money you’re transferring, this could increase your tax rate in the year of the conversion. This isn’t always what happens, however, and a common workaround is converting a smaller portion at a time to reduce your tax burden per conversion.

Finally, one other “potential struggle with Roth conversions is complexity of tax reporting if the Traditional IRA that is funding the Roth account has any pre-tax investments,” says Leonard. To help remedy this, he points out that “IRS Form 8606 must be used to determine the taxable portion under the Pro-Rata rule.”

Is a Roth Conversion Worth It?

Whether or not to consider a Roth conversion depends on your goals, income, and retirement timeline. While it can be effective, it’s not right for everyone. Ultimately, converting requires careful consideration to ensure it aligns with your financial picture and circumstances, including your retirement income plans and the impact of paying the tax on your short-term savings and tax bracket.

For that reason, it’s a good idea to consult with a qualified financial advisor. They can walk you through the pros and cons of a Roth conversion and how it may—or may not—fit into your holistic financial and retirement plans. Likewise, if a professional determines a conversion is right for you, they’ll also be able to help ascertain how to do so according to your goals and identify ways to minimize tax burden.

“Financial professionals are a great resource due to their knowledge of laws, regulations and suitability standards around investment strategies,” Leonard emphasizes. “It’s critical for investors to seek advice and education from a trusted financial professional to ensure their investment decisions align with goals, plans, tax strategies and risk tolerance.”

It’s important to prioritize working with an advisor who upholds a fiduciary duty. These are legally obligated to put your best interest first and often have transparent fees and business practices. They also typically hold credentials from reputable organizations, such as Certified Financial Planner (CFP), Chartered Financial Analyst (CFA), or Retirement Income Certified Professional (RICP). Our free matching tool can help you find a vetted fiduciary professional who suits your needs.