Roth conversions: A smart strategy for future tax-free income

Allworth financial advisor Michael Coates, CFP®, explains how Roth conversions can create tax-free income in retirement, providing financial flexibility and a meaningful strategy for reducing future tax burdens.

 

When it comes to planning for retirement, taxes are one of the biggest factors that can impact your long-term financial success. After all, the money you’ve worked so hard to save isn’t truly yours until Uncle Sam takes his share. That’s why strategies like Roth conversions can play such an important role in creating a tax-efficient retirement—and even better, they can give you access to tax-free income down the road.

If you’ve heard about Roth conversions but aren’t sure if they’re the right move for you, let’s break it down in plain terms. Here’s what a Roth conversion is, how it works, and why it might be worth considering as part of your financial plan.

What is a Roth Conversion?

A Roth conversion is simply the process of transferring money from a traditional IRA or 401(k) into a Roth IRA. When you do this, you’ll pay taxes on the amount you convert at your current income tax rate. While paying taxes upfront might not sound appealing, the big advantage is that once your money is in a Roth IRA, it grows tax-free—and, perhaps even more important, your withdrawals in retirement will also be tax-free.

This means no worrying about future tax rates or how much you’ll owe on the income you’re relying on to fund your retirement dreams.

Why Consider a Roth Conversion?

There are a few reasons why a Roth conversion might be a smart move for you, depending on your current and future tax situation.

1. Take Advantage of Lower Tax Rates Now
   If you’re in a lower tax bracket today than you expect to be in the future, paying taxes on a conversion now can help you lock in those lower rates. For example, if you anticipate your income will increase in the coming years—or if you believe tax rates will go up overall—converting now could save you money in the long run.
2. Avoid Higher Taxes on Required Minimum Distributions (RMDs)
   Once you hit age 73 (or 75 for those born in 1960 or later), the government requires you to start taking distributions from traditional IRAs and 401(k)s. These RMDs are taxed as ordinary income, which could push you into a higher tax bracket. By converting some of your savings to a Roth IRA now, you can reduce your future RMDs and potentially lower your tax bill in retirement.
3. Enjoy Tax-Free Income in Retirement
   One of the most appealing benefits of a Roth IRA is the ability to withdraw funds tax-free in retirement. This can give you greater flexibility when managing your income, especially if you want to minimize taxes on Social Security benefits or keep your taxable income below certain thresholds.
4. Leave a Tax-Free Legacy for Your Heirs
   If leaving a financial legacy for your loved ones is part of your plan, a Roth IRA can be a powerful tool. Unlike traditional IRAs, Roth IRAs are not subject to income taxes when passed to beneficiaries. This means your heirs can enjoy the full value of your gift without the burden of a tax bill.

When is the Right Time to Convert?

Timing is everything when it comes to Roth conversions. Here are a few scenarios where it might make sense for you:

• You’re in a lower-income year. If you’ve recently retired but haven’t started taking Social Security or RMDs yet, you might be in a lower tax bracket, making it an ideal time to convert.
• Tax rates are historically low. If you believe tax rates will rise in the future, converting now allows you to take advantage of today’s lower rates.
• You’re looking to balance your tax liability. Spreading out conversions over several years can help you avoid bumping into higher tax brackets all at once.

It’s also worth noting that partial Roth conversions are an option. You don’t have to convert your entire traditional IRA or 401(k) at once; you can convert smaller amounts over time to manage your tax burden strategically.

What Are the Potential Drawbacks?

As great as Roth conversions can be, they aren’t a one-size-fits-all solution. Here are a few things to keep in mind before making the decision:

• You’ll owe taxes upfront. The amount you convert is considered taxable income, so you’ll need to be prepared for the tax bill.
• Medicare premiums could increase. If a conversion pushes your income over certain thresholds, you could face higher premiums for Medicare Part B and D.
• It requires careful planning. Roth conversions are most effective when they’re part of a larger financial strategy. This isn’t something to rush into without considering the big picture.

How to Decide if a Roth Conversion is Right for You

Deciding whether a Roth conversion makes sense depends on your unique financial situation, tax outlook, and retirement goals. The key is to think long-term: Will paying taxes now lead to greater savings and flexibility in the future? How will a conversion fit into your overall retirement income plan?

As with any major financial decision, it’s important to weigh the pros and cons and work with a financial advisor to ensure it aligns with your broader strategy.