Taxes Now vs. Taxes Later

Roth IRAs give investors the option to pay taxes now, when contributing to the account, rather than paying later when taking withdrawals. However, Roth IRAs have income-eligibility restrictions as well as smaller contribution limits. If your income is too high, you’re unable to contribute directly. 

But there’s more than one way to contribute to a Roth IRA. In a Roth IRA conversion, you can withdraw funds from a traditional IRA, pay taxes on that amount, and then move it into a Roth IRA. You don’t have to convert your entire existing IRA, but rather can take whatever amount would keep you within the same tax bracket for the year. This can be especially advantageous if you’re in a relatively low tax bracket and expect to be in a higher bracket in later years.

One Size Doesn’t Fit All

The first step is to determine your current tax bracket and how much wiggle room you’d have before reaching the next bracket (FIGURE 1). Once you know the maximum you could convert and remain in the same bracket, the next step is determining how much you can afford to convert based on the taxes the conversion would generate (which you’d pay when filing your taxes the following year since the conversion counts toward the current year’s income).

Here’s an example: Last year, Elaine, who files taxes as a single individual, had an adjusted gross income of $110,000, expects to have about the same income this year, and has $250,000 saved in a traditional IRA. This puts her in the 24% tax bracket for 2024. She could potentially convert up to $81,950 to a Roth IRA while staying in same tax bracket (the maximum income for the 24% bracket for a single filer is $191,950 for 2024). 

The determining factor comes down to how much Elaine can afford to convert due to the taxes she will incur: If she converts $10,000 in 2024, it would increase her 2024 federal taxes by $2,400 when she files them in 2025; if she converts enough to reach the upper limit of her bracket, $81,950, she’d owe $19,668 when she files her 2024 taxes. 

The beauty of converting a portion at a time is that it doesn’t have to be a once and done move, either. If Elaine can afford to convert a few thousand dollars each year for several years, she could eventually convert a large portion of a traditional IRA to a Roth IRA without triggering a large tax bill at one time. 

Many Benefits, But Also Many Rules

While Roth IRA conversions can be beneficial, there are also certain rules and regulations surrounding them that can be complicated. 

For example, how the funds were contributed to your traditional IRA can impact how your conversion is taxed. Having a mix of pre-tax and after-tax contributions to a traditional IRA makes a Roth conversion subject to the “pro-rata rule,” which means determining what percentage of the conversion is taxable (pre-tax contributions) and what is not (after-tax contributions). 

Additionally, it may be tempting to use funds from your traditional IRA to offset the tax burden of the Roth conversion. However, this could do more harm than good by setting back your retirement savings overall. Converting part of your IRA may only make sense in years in which you have a windfall or additional wiggle room in your budget that can cover the taxes without dipping into your nest egg.

Finally, if your income puts you in one of the highest tax brackets or if you’re near the high end of your tax bracket for that year, a Roth conversion may lose much of its tax-efficient luster. The additional income from the conversion could trigger the 3.8% net investment income tax if it pushes you above the limits for your modified adjusted gross income for that year (for 2024, the limit is $250,000 for married filers and $200,000 for single filers). 

A Roth IRA conversion may be a helpful way to add tax diversification to your nest egg.

Work With a Professional
A partial Roth IRA conversion may be a helpful way to add tax diversification to your nest egg, but it’s not the right financial move for everyone. You should consider all of your retirement assets and work with a financial or tax professional to determine to make sure you’re not overlooking any nuances with the tax code or your particular situation.

If you’re concerned your tax rate won’t be lower in retirement, think your retirement portfolio lacks tax diversification, and you have enough money to cover the taxes accrued on a Roth IRA conversion, consider talking to your tax or financial professional about divvying up your tax-diversification buckets.