Skeels Cygan: The many benefits of a Roth conversion

Roth IRAs are tax-free. Traditional IRAs are tax-deferred. Understanding the ramifications of tax-free versus tax-deferred in your retirement plan is a major factor in why Roth IRAs are often superior to traditional IRAs.

This is part two in a three-part series on Roth conversions. The first article — “10 reasons not to do a Roth conversion” — appeared on June 8. Today’s article covers the benefits of Roth conversions. Part three, to be published in August, will cover strategies for Roth conversions.

Tax benefits

The primary reason to do a Roth conversion is to save money on taxes over the long term. Income taxes are due on the amount you convert to a Roth (in the same year as the conversion), so you are pre-paying taxes now, in order to avoid paying them later.

Paying the taxes on a traditional IRA is inevitable. Taxes are deferred during your working years, but they are due when Required Minimum Distributions, or RMDs, begin, which is currently age 73 (age 75 if you were born in 1960 or later). In addition to RMDs, taxes are due on all withdrawals from a traditional IRA. If you die with a remaining balance, your nonspouse beneficiaries will pay the taxes. The only exception is if you leave your traditional IRA to a charity.

Moving money from a tax-deferred bucket to a tax-free bucket can provide powerful benefits.

Roth conversions have become popular in recent years because many people funded their traditional IRAs throughout their careers to the maximum amount allowed by law, and the accounts increased in value more than expected, leading to high RMDs and high taxes during retirement.

Fidelity Investments estimated they held 537,000 401(k) accounts over $1 million in 2024, and that doesn’t include accounts at other financial firms. Many investors with large accounts have realized they will not be in a lower tax bracket when they retire, and the RMDs from their large account will likely keep them in a high tax bracket for the rest of their lives. The RMDs can also result in higher IRMAA (Medicare surcharges) every year and higher taxes on all other income, such as Social Security, pensions and annuities. Unlike traditional IRAs, Roth IRAs do not require RMDs, which can drastically reduce taxes during retirement.

One solution — to excessively high taxes during retirement — is to convert some of the traditional IRA, or 401(k) or 403(b), to a Roth IRA or to the Roth portion of your employer’s retirement plan. Anyone at any income level can do a Roth conversion. They have even become popular for folks in their 70s and 80s, but the RMD must be taken first each year before doing a Roth conversion.

The primary decision about whether to do a Roth conversion comes down to estimating whether moving money from a tax-deferred bucket to a tax-free bucket — and paying the taxes on the conversion now — will save money on taxes in the long term.

An interesting perspective is to consider the after-tax value of a traditional IRA versus a Roth IRA. Let’s assume an investor has a $1 million traditional IRA. If that person assumes they will pay 25% for federal and state taxes on all withdrawals, including RMDs, then the after-tax value of the account is only $750,000. Remember, a traditional IRA is tax-deferred, but only until RMDs begin. All withdrawals are taxed as income.

Conversely, a $1 million Roth IRA is tax-free, and, therefore, the value remains at $1 million. The money invested in Roth IRAs has already been taxed, so the withdrawals are not taxable, and RMDs are not required. Note that with Roth conversions, you are required to pay taxes in the year of a conversion, so the money is taxed at that time.

Another consideration in deciding whether you want to do a Roth conversion is the future tax-free growth of your Roth IRA after the conversion. The compounding in future years on a tax-free basis is powerful. The tax-free compounding over many years is why I favor converting to a Roth IRA sooner rather than later.

You may also want to consider future tax rates. Many economists are predicting tax rates will go up due to high U.S. debt, which is currently $36 trillion. Of course, no one knows for certain.

Fortunately, you can convert any amount each year, allowing you to manage the taxes on the conversion over several years. Doing a Roth conversion one year does not require you to continue conversions in future years, allowing you to reassess each year, based on your income and tax situation.

In addition to uncertainty involving future tax rates, tax laws could change to make Roth conversions more restrictive. Recently, reducing tax deductions for charitable gifts for wealthy taxpayers has been discussed, which can be a tax-planning strategy to keep taxes low on a Roth conversion.

Estate planning benefits

In addition to lower taxes over the long term, there are other benefits of a Roth conversion. A major benefit involves estate planning.

The Secure Act 1.0, which passed in December 2019, changed the rules for nonspouse beneficiaries who inherit an IRA. The new rules require that the beneficiary withdraw all the money within 10 years after your death. If you leave a traditional IRA, or 401(k) or 403(b), the full amount is taxable to the beneficiary. If you leave a Roth IRA, the withdrawals must still occur within 10 years, but the withdrawals are tax-free. This is a major consideration if you want to leave your assets tax-free to your children or grandchildren. If your beneficiary is under age 18, the 10-year clock doesn’t start ticking until they turn 18, so the tax-free compounding can extend well beyond 10 years.

Another estate planning benefit pertains to very wealthy people who have estates over $15 million. If someone is expecting their estate to be taxed when they die, either on a federal or state level, doing a Roth conversion will reduce the size of the estate which can also reduce the estate taxes.

Ed Slott, certified public accountant and retirement planning expert, is a fan of Roth IRAs and Roth conversions. When talking about Roth IRAs, he stated, “It grows income tax-free for life. There are no required minimum distributions during my lifetime. I love that. You did have to pay the tax upfront, but look what you get. You get tax freedom for the rest of your life and even 10 years beyond for your beneficiaries.”

Obviously, each person’s situation is different, so you must decide whether a Roth conversion makes sense for you.