Can You Save Money by Converting Assets to a Roth IRA?

Since 2010, all investors have been allowed to convert assets from a Traditional individual retirement account (IRA) to a Roth IRA.¹ Because conversions are not subject to income restrictions, people at any income level can take advantage of the Roth IRA’s key benefit—tax-free qualified distributions.²

A Roth conversion provides you with tax diversification in your retirement years. In addition, Roth IRAs do not have required minimum distributions (RMDs) for the original owner, whereas Traditional IRAs are subject to RMDs beginning in the year you reach age 73. These positives need to be weighed against the tax you pay on the amount converted. With the passing of the Setting Every Community Up for Retirement Enhancement (SECURE) 2.0 Act at the end of 2022, you have additional time to convert assets from a Traditional IRA to a Roth IRA and avoid having to take RMDs. Of course, you want to consider if this is appropriate for your circumstances.  

Deciding whether a Roth conversion makes sense in your situation depends on several factors, including:

Before you execute a Roth conversion, you’ll also want to consider:

You can benefit from a Roth conversion by paying taxes now at a lower rate if your tax rate is likely to be higher when you take distributions. The strategy should be considered in a number of situations if you are able to pay the taxes (preferably from a nonretirement account):

The key disadvantage of a Roth conversion is that taxes are due on the converted value. There are also factors to consider specifically for the year of conversion. Higher taxable income that year could have one or more of these negative effects:

There are a number of reasons your tax rate may be lower when you (or your heirs) take distributions:

In general, a Roth conversion works best if you can pay taxes from a taxable account. Selling assets in a taxable account may be all or partly a return of your principal (cost basis) and, therefore, may not be a taxable gain. Realized gains from those sales may be taxed at the long-term capital gains tax rate, which is typically lower than your marginal ordinary income tax rate. If you’re considering this approach, make sure that you still have an adequate emergency fund and that this doesn’t inordinately reduce your financial flexibility.

You could also pay the tax using distributions from the Traditional IRA or from existing Roth assets. In both cases, you could pay a penalty on the distributions if you’re under age 59½.

Generally, funding the tax from a Traditional IRA would incur ordinary income tax on that distribution, so unless you’re in a low tax bracket, that’s not ideal. Using an existing Roth to pay the taxes doesn’t result in ordinary income tax, but this approach essentially reduces the amount and the value of the conversion.

A Roth conversion is most compelling when you pay the tax on the amount converted at a low rate. So if your income is irregular, consider Roth conversions in low-income years. Or you could consider a conversion in a year when you’ve been unemployed. Unfortunately, those years may coincide with cash flow challenges, making extra tax payments impractical. But if you have lined up new employment without falling below a prudent cash level, a conversion could make sense.

Another common example is converting assets early in retirement before you face RMDs. As noted above, be careful about triggering higher taxes on Social Security benefits or higher Medicare premiums in the conversion year. However, reducing your RMDs could have a favorable impact on Social Security taxation or Medicare premiums later. Ideally, you should coordinate your Social Security claiming strategy and retirement income strategy, including the account drawdown order and possible Roth conversions.

The SECURE Act and SECURE 2.0 Act may make Roth conversions more attractive for some people. Under the SECURE Act, most IRAs inherited by beneficiaries (other than spouses, disabled or chronically ill individuals, those less than 10 years younger than the IRA owner, or other limited exceptions) will need to be fully distributed within 10 years of the original owner’s death. That income could push some beneficiaries into higher tax brackets. Therefore, a Roth conversion could be attractive if those beneficiaries’ tax rates are higher than the rate upon conversion. In addition, the starting age for RMDs was moved to age 73 in 2023 and is set to be extended to age 75 in 2033. These changes may allow individuals more time to execute a conversion strategy. For more details on beneficiary IRA RMD changes, see our recent article.

We analyzed a situation in which a Roth conversion may make sense: Traditional IRA assets that won’t be needed for retirement income are available, and a taxable account exists to pay the tax upon conversion. In this situation, the assets are intended to pass to heirs (in the next generation, as opposed to between spouses). A person in this position can use a series of annual Roth conversions to reduce unwanted RMDs.³ Within this framework, we evaluated scenarios with a focus on three key parameters:

The first of these parameters merits some explanation. Returns in a taxable account can generally be treated in one of three ways for federal income tax: ordinary income (e.g., interest received), capital gains (profits from the sale of securities), and tax-free (e.g., interest for certain municipal bonds). In addition, if you hold appreciated securities until death, your heirs can benefit from a “step up” in cost basis. That means that they don’t pay capital gains taxes on appreciation through the date of your death, so those gains are also essentially tax-free.

For each combination of these parameters, we measured the results of three strategies:

Each strategy is measured by the total after-tax asset value received by heirs upon the owner’s death (assumed to be age 95). This value assumes that Traditional IRA assets are taxed upon death at the heirs’ ordinary tax rate. (Roth and taxable accounts are assumed to pass to heirs income tax-free.)

We evaluated 12 combinations of assumptions for the three key parameters. Other assumptions were held constant for all scenarios.⁴ We didn’t analyze situations where the worker’s tax rate increases during retirement because those are generally advantageous for Roth conversions. Again, the idea was to depict a situation in which Roth conversion is plausible but not a “slam dunk.”

1. In this broad situation (in which the IRA assets aren’t needed for retirement spending), the benefit of a Roth conversion is driven largely by the profile of the taxable account being used to pay taxes on the conversion. If the taxable account is primarily generating ordinary income or even capital gains, Roth conversions are usually beneficial in the general situation we studied. (See dark blue and bright blue rows in Figure 1.)
   
2. There are situations in which a Roth conversion doesn’t add value. (See dark gray rows in Figure 1.) This occurs if the taxable account generates tax-free returns and the person’s tax rate in retirement (and/or the heirs’ tax rate) is lower than during working years.
3. If converting makes sense, you generally get much more benefit by starting sooner (and, therefore, converting more). Alternatively, you could convert the same total amount over fewer years, but you’d be more likely to jump into a higher tax bracket.

The importance of the taxable account profile may seem counterintuitive. After all, the conversion is from a Traditional IRA (pretax) to a Roth IRA, and the taxable account seems like a secondary factor. In general, however, Traditional and Roth IRAs have equivalent results if a person’s tax rates stay constant.⁵ So you can think of a Roth conversion more as a shift of assets from a taxable account (the conversion tax paid) to a tax-advantaged one. This explains why row 9 in Figure 1 shows no difference between converting and not converting if tax rates stay constant and the taxable account is all tax-free.

It may also be surprising that the benefit of this shift from taxable to tax-advantaged can even outweigh a tax rate reduction in retirement. So we dug a little deeper to analyze the impact of taxable account profiles for different levels of tax rate reduction (see Figure 2).⁶

For example, if a couple’s tax rate falls from 24% in working years to 22% in retirement, converting is favorable unless more than 89% of earnings in the taxable account are tax-free. For someone whose rate falls from 22% to 12%, converting becomes unfavorable when more than 40% of the taxable account earnings are tax-free. Again, these numbers rely on the specific situation evaluated, in which someone doesn’t need RMDs for expenses in retirement, among other assumptions.  

People approaching retirement age or who recently retired should at least consider a Roth conversion strategy. Many of those people will correctly conclude that it’s not practical or advantageous due to upfront taxes on the conversion.

However, our analysis paints a picture of people who could benefit significantly. These people have saved diligently in all of their pretax retirement accounts. They probably don’t have significant Roth assets, because Roth contributions were unavailable or unattractive at their income level. They have taxable account assets, perhaps from windfalls or because they were able to save beyond retirement contribution limits. They may have a pension or other income sources that give them confidence they will leave assets to their heirs.

For these investors, a Roth conversion reduces unwanted RMDs. It is especially attractive if their taxable income is low in their early retirement years. However, even if their tax rate stays flat or decreases in retirement, they may benefit from a Roth conversion if they are using a relatively tax-inefficient taxable account to pay the taxes on the conversion. Because there are many interrelated factors in this decision, you may want to consult with a financial advisor to evaluate your specific circumstances.