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Roth IRAs wear many hats. They provide a vehicle for tax-free growth, they permit early access to savings if needed, and they eliminate mandatory distributions in retirement, enabling wealthy seniors to pass along a potentially bigger financial legacy to their heirs. It’s no wonder that Roth IRA conversions have become such a coveted tax planning tool.
Roth conversions involve shifting money from a tax-deferred retirement account, such as a traditional IRA or a 401(k), which do not limit contributions based on income, into a Roth IRA, which does have income limits for eligibility. The money converted is subject to ordinary income tax in the year it gets converted, but all future earnings grow tax free.
Most who convert all or part of their retirement savings to a Roth do so to reduce their future tax hit in retirement, which is particularly appealing for individuals who have only ever saved in tax-deferred accounts. And many are high-income taxpayers who were never eligible to contribute directly to a Roth IRA based on their earnings.
The Roth IRA vs. tax-deferred retirement accounts
To properly assess the pros and cons of a Roth IRA conversion, it is important to understand how they differ from their tax-deferred peers.
For starters, Roth IRAs are funded with after-tax dollars, so there is no immediate tax deduction in the year you contribute, but earnings in the account grow tax free, which can potentially result in a bigger nest egg. The benefit of tax-free growth in a Roth IRA can be profound. (Calculator: Roth vs. traditional IRA calculator)
Because Roth IRAs are funded with after-tax dollars, any savings converted to a Roth IRA will be subject to ordinary income taxes in the year the conversion is made. But the ability for someone to lower their tax bill in retirement and, if they don’t need the money for living expenses, to pass along the total value of their account to their heirs, is worth the upfront tax bill for many.
That makes them a powerful estate planning tool. Non-spousal heirs who inherit a Roth IRA must withdraw all the money from their Roth account within 10 years of the original account owner’s death, but as long as the original owner had the account open for at least five years, those withdrawals are tax free. If the Roth account was not open for at least five years before the original owner’s death, only the earnings would be subject to taxes.1
The other significant perk of a Roth IRA is that there are no required minimum distributions (RMDs) during retirement, enabling your savings to continue delivering tax-free growth throughout your lifetime.
By contrast, tax-deferred retirement accounts, such as traditional IRAs and 401(k)s, are funded with pretax dollars. Both the contributions and the earnings are taxed upon withdrawal. The Internal Revenue Service requires account owners to begin taking RMDs from their tax-deferred accounts by age 72 whether the account owner needs the money for living expenses or not. Those withdrawals are taxed as ordinary income, which can potentially bump retirees into a higher tax rate.2
Those who inherit a tax-deferred retirement account (including a traditional IRA or 401(k)) must pay ordinary income tax on their withdrawals, which can bump them into a higher tax bracket. And as a result of the SECURE Act, the beneficiary’s ability to stretch those withdrawals out over their lifetime was eliminated. An inherited tax-deferred retirement account must now be fully depleted within 10 years of the original account owner’s death. (Related: 3 points to know about the SECURE Act’s retirement rule changes)
A final perk of the Roth IRA is that you can withdraw your contributions penalty free at any age, providing greater flexibility over your finances. (You must be at least age 59½ to avoid a 10 percent early withdrawal penalty on your earnings.)
You may never (except in limited hardship scenarios) make withdrawals from a tax-deferred retirement account before age 59 ½ without paying the 10 percent penalty.
Backdoor Roth IRAs
So why don’t all retirement savers contribute to a Roth IRA? Some households decide they benefit more from the immediate tax deduction they get by contributing to a tax-deferred retirement account.
But many more have no choice. Eligibility to contribute to a Roth IRA is limited based on income.
For tax year 2023 (the tax returns we file in April 2024), single taxpayers may not contribute to a Roth IRA if their income exceeds $153,000 and married couples filing jointly may not contribute if their income is greater than $228,000. Those limits increase in 2024 to $160,999 for single filers in 2024, and $240,000 for married couples. Those eligible can contribute up to $6,500 per year in 2023, and $7,000 in 2024. If you are 50 or older, you may make an additional catch-up contribution of $1,000 per year.3
There are no income limits for contributions to a traditional IRA or 401(k), although income does dictate the degree to which you may make deductible contributions to a traditional IRA. (Related: Retirement plan contribution limits: Your need-to-know)
Despite the rules that restrict eligibility to contribute directly to a Roth IRA, however, the government in 2010 opened the door for all taxpayers at any income threshold to convert their tax-deferred retirement savings to a Roth IRA, which is now known as a “backdoor Roth IRA.”
By default, that permits individuals who complete a Roth IRA conversion to potentially prepay taxes on a larger amount of retirement savings, since the annual contribution limits for 401(k)s are much higher. In 2023, retirement savers may contribute $22,500 pretax to their 401(k) ($29,000 for those age 50 or older). Those limits in 2024 are $23,000, or $30,000 if you are 50 or older. That compares with the lower $6,500 annual limit ($7,500 for those 50 or older) for all types of IRAs, including traditional and Roth, which makes it more difficult to accumulate a sizable nest egg.
When a Roth conversion might make sense
Despite their potential benefits, however, Roth IRA conversions are not necessarily the right move for everyone. And they’re irreversible. Thus, anyone considering such a move should consult a financial professional for guidance.
As a general rule of thumb, you might want to consider a Roth conversion if you think your tax rate may be higher in retirement. Indeed, while most retirement savers project a lower tax rate in retirement, the reality is that many who saved primarily in tax-deferred accounts face a higher tax rate when they begin taking taxable withdrawals.
Others who might benefit are retirees who fall into a temporary “tax valley.” Their income was too high to contribute to a Roth during their working years, and their tax rate will likely climb again when their RMDs kick in at age 72. For that reason, many Roth conversions are completed in the years immediately after an account owner retires, but before their RMDs begin.
When a Roth conversion might not be wise
Of course, the inverse is true as well: If you expect to be in a lower tax rate in retirement, it generally will not make sense to convert your savings to a Roth today and pay higher income taxes.
Others for whom a Roth IRA conversion may not be wise include those who would be left cash poor after paying the conversion taxes (you need to maintain an emergency fund), and those who intend to leave all or most of their retirement savings to a charity. Charities are not required to pay taxes on donated assets. Thus, you would not want to diminish the value of your donation by prepaying taxes.5
Pre-retirees should also consider their state taxes and their plans for relocation during retirement. Why? Beyond any federal tax you would owe on withdrawals from tax-deferred accounts, you would also have to pay state taxes. If you live in a high-tax state like New York, that can amount to a sizable sum, but if you expect to relocate to a state with no state income tax — Florida, for instance — it would generally not make sense to convert to a Roth and prepay state taxes.
From a tax planning perspective, a few alternatives to a Roth IRA conversion that might be more prudent depending on your financial picture include investing after-tax monies in tax-free bonds, using tax-deferred annuities, or even “clever use of cash value life insurance” as a way to build up a Roth substitute, said John Pearson, a financial professional with Barnum Financial Group in Shelton, Connecticut. (Related: Know your life insurance policy’s ‘cash value’?)
Lastly, if leaving a financial legacy to your heirs is on your to-do list, consider the tax rate of your future non-spouse beneficiary. If he or she is likely to be in a higher tax bracket than you, it might make sense to prepay the taxes at your lower tax rate now. Here again, a tax professional can help you make informed decisions. (Related: Year-end tax-planning moves)
Conclusion
Roth IRA conversions offer numerous potential tax advantages, but they’re not the right move for everyone. Before making any big decisions with your retirement savings, it is wise to consult a financial or tax professional for guidance.
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1 Internal Revenue Service, “Retirement Topics—Beneficiary,” Aug. 29, 2023.
2 Internal Revenue Service, “Retirement Topics—Required Minimum Distributions (RMDs),” March 14, 2023
3 Internal Revenue Service, “Retirement Topics—IRA contribution limits," July 5, 2023.
4 Internal Revenue Service, “IRA FAQs—Distributions (Withdrawals),” Aug. 29, 2023.