Roth IRA Conversion: Does it Make Sense for You?

By: Scott Sturgeon, JD, MBA, CFP®

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A Roth IRA conversion is a process by which an individual converts a traditional IRA (Individual Retirement Account) or employer-sponsored retirement plan, such as a 401(k) or 403(b), into a Roth IRA. The main difference between the two types of accounts is that traditional IRAs or workplace plans are funded with pre-tax dollars, whereas Roth IRAs are funded with after-tax dollars. This means that, while contributions to a traditional IRA may be tax-deductible in the year they are made, contributions to a Roth IRA are not. However, the money in a Roth IRA grows tax-free and, when it is withdrawn in retirement, can be tax-free as well.

Pros to Doing a Roth IRA Conversion

There are several reasons why you might want to convert your traditional IRA into a Roth IRA. One of the main reasons is to take advantage of the tax-free growth and tax-free withdrawals offered by a Roth IRA. This can be especially beneficial if you expect to be in a lower tax bracket in retirement than you are currently. By paying taxes on the money in your traditional IRA at a lower tax rate in retirement, you may be able to lower your overall tax liability over time.

Another reason to convert to a Roth IRA is for estate planning purposes. When you leave a traditional IRA behind to a spouse, they have several options ranging between making themselves the account owner, rolling the traditional IRA into their existing traditional IRA, or treating themselves as the beneficiary of the traditional IRA. For traditional IRA’s left to non-spousal beneficiaries however, things get more complicated.

Depending on how old the account owner was when they passed away, a non-spousal beneficiary of a traditional IRA may either have to start taking required minimum distributions from the account, or withdraw the full account balance within 10 years. If you’re already in a high income bracket, the latter of those may increase your taxes even more as those distributions are considered taxable income. Leaving a Roth IRA to a non-spousal beneficiary however, avoids these issues since even though the full balance of a Roth IRA has to be distributed within 5 years of the account owners death, it’s all tax-free to the beneficiary.

Potential Drawbacks of a Roth IRA Conversion

There are also several potential drawbacks to converting to a Roth IRA. The most significant one is that, as mentioned above, converting to a Roth IRA means paying taxes on the money that was previously in a traditional IRA. This can be a significant amount, depending on the size of your traditional IRA and your current income tax rate. For that reason, it’s often better to wait until you are in a lower income year or retired to do a Roth IRA conversion.

Another potential drawback is that, once you convert a traditional IRA to a Roth IRA, you are subject to many of the same rules and restrictions as a traditional IRA. This means that you are subject to annual contribution limits and you must wait until you reach the age of 59 and a half to withdraw your money without penalty. If you need to access the money in their Roth IRA before then, you may be subject to penalties and taxes.

Despite these potential drawbacks, many individuals still choose to convert their traditional IRA to a Roth IRA. The potential benefits of tax-free growth, tax-free withdrawals, and leaving a tax-free asset for their loved ones can be significant. Ultimately, the decision of whether or not a Roth IRA conversion makes sense is going to depend primarily on your financial goals and objectives. To learn more about that, check out this article we wrote on the importance of having financial goals and aligning those goals with your financial identity. 

If you are considering converting your traditional IRA to a Roth IRA, it is important to carefully weigh the potential pros and cons and consult with a fiduciary financial planner to determine if it’s the right decision for your individual situation. If you’d like to learn whether this strategy may make sense for your specific financial situation, schedule time with us to discuss whether working with Oread Wealth Partners could bring value in working towards your goals.

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