Littlejohn: Could you benefit from a Roth IRA conversion?

It might seem counter intuitive to decide to pay MORE taxes now, rather than defer them, but in some cases, that can be a smart, tax-efficient strategy. 

Have I piqued your curiosity? I want to introduce you to the pros and cons of doing a Roth IRA conversion. It’s not for everyone, but depending on your personal situation, it could allow you to save on your personal income taxes in the long run. 

What is a Roth IRA conversion? 

To start with, there are two kinds of individual retirement accounts. The traditional IRA provides a tax deduction up front, when you contribute to the account. But you’ll be taxed on the proceeds when you withdraw from the account, presumably once you retire. The Roth IRA offers the opposite benefit. No tax break up front, but as long as you meet certain conditions, your withdrawals will be tax-free along with all of your earnings in the account. 

In a Roth IRA conversion, you convert some money to a Roth IRA from a traditional IRA — or from a similarly designed retirement account that offers a tax deduction when you contribute to it (with pre-tax money). In so doing, you have to pay income taxes. But once you pay those taxes, the money in the Roth IRA and the earnings they generate in the account will be tax-free. 

Why consider converting to a Roth IRA? 

It’s all about your income level and your income tax bracket now and in the future. 

It might be difficult to know for certain what your income tax bracket — and tax rate — will be in future years. However, you might be in an unusually low tax bracket now and expect to be in a higher one in the future. 

For example, if you have recently retired and are waiting to take Social Security benefits or are not in need of retirement account withdrawals (let’s say you’re in your 60s), you might have relatively low taxable income this year. Fast forward to after you turn 73 (or 75, depending on when you were born), when your income will include Social Security benefits and required minimum distributions (RMDs) from a traditional IRA and/or similar workplace retirement account. In that scenario, you likely would expect to pay more in taxes in future years. 

By converting $10,000 to a Roth IRA and paying tax at a 12% rate versus a 22% rate in future years, you would pay $1,200 now versus $2,200 down the road. That’s $1,000 savings. Plus, all future earnings on that investment, and the resulting tax savings, would compound over time. That’s a gift to your future self that will keep giving. 

Aside from the clear tax savings in this scenario, an important benefit of doing a Roth conversion is based on people’s strong tendency to invest in a traditional IRA (for the immediate tax benefit) rather than the deferred benefit offered by a Roth. So it’s not a surprise that the average balance in a traditional IRA was $211,000 versus $52,000 for a Roth IRA in 2023, according to The Tax Policy Center.  

By converting some money from a traditional IRA to a Roth account, most people would establish a better balance between the two. This could be very helpful as a tool in retirement, allowing you to make strategic tax decisions. For instance, in a year when you are near the top of a tax bracket, taking tax-free withdrawals from a Roth account, rather than taxable distributions from a traditional IRA, would keep you from bumping up into a higher income tax rate. 

I should also point out that, unlike traditional IRAs, Roth IRAs are not subject to the RMDs I mentioned previously. You can leave your money in your Roth IRA for as long as you’d like.  

Who should NOT consider converting to a Roth IRA? 

If you are fairly confident that your income will decrease in retirement, then why pay more taxes now at a higher tax rate? In that case, defer the inevitable. Although you won’t like having to pay taxes on your future withdrawals, you can take comfort in the expectation that you’ll be paying less then. And that is the typical assumption people make when contributing to traditional IRAs and 401(k)s during their working years. 

What if you really don’t know? Generally, it wouldn’t make much sense to pay taxes now if you really don’t expect that to be beneficial in the long run. However, the best advice here is to seek advice from a tax pro. This is a complex area, and any decisions should be made thoughtfully and be based on the best available information.  

With that said, however, the clock is ticking on the 2025 tax year. If this looks like a year when you could benefit from a Roth IRA conversion, use the time well. 

This article is for informational purposes only and should not be construed as tax advice.  

Brian R. Littlejohn, MBA, CFP, CFA is the founder of Sherwood Wealth Management, an independent, registered investment advisor (RIA) firm. He lives in Aspen and works with clients in the Roaring Fork Valley and beyond.