Tax implications of converting funds (2024)

By Brendan Halleron, CFP®, AIF®, BFA™

One of the most common questions I receive from clients is, “Should I do a Roth IRA conversion?” Every time, my answer remains absolute: “It depends!” While it may seem like an easy decision, there are multiple factors to consider before making a conversion. In this article, we’ll review what a Roth conversion is, situations where it makes sense, and what to consider if you decide this is the best move for your finances.

What is a Roth IRA?

A Roth IRA is an individual retirement account (IRA) that allows a person to save and invest after-tax income each year. The benefit is that earnings and withdrawals from a Roth IRA are tax-free if the withdrawal is made after age 59.5 (contributions can always be withdrawn without penalty or taxes). Having assets in a Roth IRA account provides valuable tax-planning flexibility during retirement. This tax-free account can supplement your other retirement savings, such as corporate retirement plans (e.g. 401(k)s) and traditional IRAs, which are tax-deferred during your working years, but are taxed as income when you withdraw funds during retirement.

Who can contribute to a Roth IRA?

Anyone who has a Modified Adjusted Gross Income (MAGI) of $161,000, or $228,000 married filing jointly, is eligible to contribute directly to a Roth IRA. Contributions are based on your MAGI during the tax-year but can be made up until April 15th (Tax Day) for the preceding year. For example, if your MAGI qualifies, you can contribute to a Roth IRA on April 14th, 2025 for tax-year 2024.

Even if you earn more than the allowable MAGI amounts, there are ways to contribute on a Roth basis for retirement, such as a backdoor Roth IRA contribution or an after-tax contribution to a workplace retirement plan, if allowed by the plan (e.g. a Roth 401(k)). Keep in-mind: if your workplace retirement plan allows Roth contributions, you can make them regardless of income level, but you will be taxed on the funds that are contributed.

What is a Roth IRA conversion?

A Roth IRA conversion is when you transfer pre-tax funds from a tax-deferred traditional IRA to an after-tax Roth IRA account. Tax-deferred accounts can include traditional, rollover, SEP, or SIMPLE IRAs, and corporate retirement plans, such as a 401(k), 403(b), or 457(b) plans - though workplace plans are typically not as straightforward. Some corporate retirement plans allow in-plan Roth conversions, or you can rollover workplace retirement plan dollars into a Roth IRA. But when rolling workplace retirement plan dollars into a Roth account you generally cannot choose the amount of money to convert (“all or nothing” approach).

When you convert funds from a tax-deferred retirement account to a Roth account you are creating income that will be taxed at your current marginal tax bracket. But you will not be charged an additional penalty for taking an early retirement withdrawal. And, unlike contributing to a Roth IRA, anyone can make a Roth conversion regardless of income or tax-filing status.

What are the benefits of a Roth IRA conversion?

The main benefit of converting IRA funds to a Roth IRA is to reduce taxes that are expected to be owed over your lifetime or your heirs’ lifetimes. Roth IRA conversions allow you to shift taxes paid in time to periods when you expect taxes to be lower or to prepay taxes for heirs. For example, by converting dollars to a Roth now, you reduce the amount of future Required Minimum Distributions (RMDs), which can have profound tax and estate planning implications.

What are the steps for doing a Roth IRA conversion?

To execute a Roth conversion, fund your IRA with either a contribution or a rollover. Next, open a Roth IRA account if you have not previously. Then, call your custodian or complete their required paperwork to move the funds from the IRA to the Roth IRA. You will need to decide what assets to convert or the specific dollar amount. Lastly, be prepared to receive a 1099-R tax form during tax season to pay federal income taxes on the amount converted (state taxes may also be owed depending on where you live).

When does it make sense to do a Roth IRA conversion?

There are several situations where it may be beneficial to execute a Roth conversion. One situation could be if you are in a lower tax bracket today than you expect to be in the future. Often this occurs in the years just before collecting Social Security or having to take RMDs from your traditional retirement accounts. This situation can also occur if you have an irregular income stream (e.g. business owners or real estate agents), allowing you to take advantage of lower-income years to convert at a lower marginal tax bracket.

Another situation where it may make sense to do a Roth conversion, is if you want to leave the most tax efficient legacy vehicle for your heirs. Roth IRAs are considered the most tax efficient accounts to leave as an inheritance because Roth dollars grow tax-free and are distributed tax-free. When an individual (not a trust) is named as the beneficiary of a Roth IRA, they have 10 years to allow the account to grow before they are required to close it and withdraw the funds. Leaving a Roth IRA as an inheritance can be considered a form of prepaying taxes for your heirs. This is especially advantageous if your estate is large enough to be subject to federal or state estate taxes.

When does a Roth IRA conversion NOT make sense?

Situations where it is less advantageous to complete a Roth conversion could include if you do not have excess cash flow available to pay the taxes a Roth conversion would create. While you can withhold funds for federal and state taxes as part of the conversion, it is less advisable than paying the taxes with available cash, because it reduces the amount of money moving into your Roth IRA to grow tax-free. Additionally, if you expect to be in a lower tax bracket in the future than you are in today, converting funds at a higher tax rate may not make sense for your situation.

Large conversions may not make sense while on Medicare, because they can trigger IRMAA (Income-Related Monthly Adjustment Amount) on your Part B and Part D coverage. In effect, IRMAA is an additional premium charged to high-income earners for their Medicare benefits.

Lastly, if you do not have any heirs and plan to leave your estate to charity, it is not beneficial to you or to the charity organization (501(c)3 organization) to do a Roth conversion and pay taxes on money that would otherwise already go untaxed.

What should I watch out for when converting?

If a Roth IRA conversion makes sense for you, there are still several considerations to be mindful of, including:

• The decision is irreversible.
• The conversion creates income, which will result in more federal/state taxes and could affect government programs such as Medicare (IRMAA) or financial aid.
• Conversions have to occur by the end of the calendar year, there are no extensions (unlike contributions, which can be made until Tax Day of the following year).
• The ultimate success of the strategy may be predicated on longevity, or the amount of time required to realize the future benefit of taxes saved at lower rates today.
• If you plan to access your contributions (not earnings) before age 59.5, you need to ensure that your account has been open for five years AND wait five years to access the converted amount in order to avoid penalties. These are two separate five-year rules. Each conversion starts a new five-year clock for the converted funds to be removed tax free.
• If you have both pre-tax and after-tax (non-Roth) contributions in your IRA, there are additional tax-related complications you need to consider. Consult your advisor or accountant.

The best way to evaluate and correctly execute your Roth IRA conversion is to work with a Certified Financial Planner (CFP®) to walk through the specifics of your situation.

Key Takeaways

Converting IRA money to a Roth IRA is not a straight-forward decision! It is crucial to understand your goals before determining if a Roth conversion is the right strategy for you. Once you’ve decided that a Roth conversion makes sense for you, you still need to figure out how much money to convert to avoid an adverse tax situation. While this can be daunting on your own, working with a Financial Planner to map out your options can help you understand both the potential benefits and repercussions of a Roth conversion.

Sources:https://www.schwab.com/learn/story/why-consider-roth-ira-conversion-and-how-to-do-it,https://www.bankrate.com/retirement/convert-to-roth-ira/#watch-out,https://www.kiplinger.com/retirement/roth-ira-conversion-6-reasons-it-makes-sense

The views represented are not meant to be construed as advice. Moreover, no client or prospective client should assume that this content serves as the receipt of, or a substitute for, personalized advice from Affiance Financial, or from any other professional.

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Content should not be viewed as legal or tax advice. You should always consult an attorney or tax professional regarding your specific legal or tax situation. 401(k), IRA, and tax rules are subject to change any time.

Affiance Financialdoes notserve as an accountant anddoes notprepare tax returns.