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Roth IRA Conversion

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Naaman Creative

Roth IRA Conversion

There is often confusion around Roth IRA conversions. Here are some of the most common questions when it comes to Roth IRAs:

  • What’s the benefit to convert Pre-tax Traditional IRA/401k money to a Roth IRA?
  • When is the right time to convert pre-tax retirement money to a Roth IRA?
  • Should I convert it all at once or do it over multiple years?
  • Is it beneficial for my kids if I do a Roth IRA conversion?

Convert a Roth IRA

It’s also important to fully understand the terminology around Roth IRA conversions. Here’s a simple list of some useful financial lingo:

  • IRA: Individual Retirement Account
  • Pre-Tax: money in the account has not been taxed and will when its withdrawn.
  • Roth: money has already been taxed and will not be taxed again.
    • Roth & After-Tax accounts are the same thing.


What’s the benefit to convert Pre-tax Traditional IRA/401(k) money to a Roth IRA?

The biggest benefit of having a Roth IRA in the first place is to get the tax-free growth on the money in the account. Remember the Roth IRA is not an investment. It is simply a type of account that protects the investment’s growth and dividends from being taxable by the IRS (aka: the man).

The benefit of converting a pre-tax traditional IRA/401(k) to a Roth IRA is that, in the future, all the growth and dividends from that point of the conversion forward would be tax free. Let’s look at an example:

Bobby is 40 years old and has $50k in an old pre-tax 401(k) plan. Pre-tax means all those contributions that Bobby added to the plan over the years were tax deductible for his income taxes in that year. Eventually, when Bobby takes that money out of the account, he will be taxed on everything including the growth and dividends earned.

Bobby talks with Client Focused Financial and asks about a Roth conversion. He inquires about what it would look like if he paid the tax now vs not converting the money. Bobby is married and they have a combined income of $90k. This puts them in a 22% income tax bracket (as of 2021). The $50k, if converted, would have the taxes taken off the top at 22%. Below is a table showing the comparison of these two scenarios over the next 20 years.

$50k Pre-Tax 401k Plan
$50k Roth IRA Conversion
Present Value $50k $39k (After 22% taxes withheld)
Future Contributions 0 0
Annual Rate (%) 9 9
Years 20 20
Future Value $280,221 $218,572

Converting to a Roth IRA Pays Off

The difference is clear. In the end, not converting the money leaves you with more money in your account. However, it’s not all about what you make. The important factor is what you keep. That $280k is all taxable, when it’s withdrawn. The $218k is all tax free. One thing no one knows today is what tax rates will be in 20 years. One thing is clear, taxes likely aren’t going away.

In Bobby’s case, a lot of the decision may be based on if he will be in a lower tax bracket in retirement. We don’t know what tax rates will be. Nonetheless, Bobby might have a better idea if he plans on working in retirement, which can affect the decision made today.

When is the right time to convert pre-tax retirement money to a Roth IRA?

Convert Roth IRA

The best time to do a Roth IRA conversion is when there is a market crash. A great example is the COVID-19 induced stock market plunge in March 2020. From February 19, 2020 through March 23, 2020 the stock market dropped 35%. This created a great opportunity for Roth IRA conversions, if someone was quick to pull the trigger.

In a pre-tax account, there would have been less money to be taxed in a Roth IRA conversion. The rebound in stocks would have given that person tax free growth as the stock market came back over the following months. That’s a win/win.

Generally speaking, the younger you are the more time you have to allow that money to grow. This makes younger people bigger benefactors for Roth IRA conversions.

Should I convert it all at once or do it over multiple years?

There is no straightforward answer to this question because there are a few variables to consider. One factor is your current tax rate. Would the conversion push you into a higher tax bracket? Another variable is how big is the pre-tax account you’re looking at converting.

If you’re 70 years old and have a 7-figure Traditional IRA, you’re not going to like the taxes paid on converting the whole amount in one year. It makes more sense putting a plan together to incrementally convert that Traditional IRA. If you’re 25 years old and you have $5k from an old pre-tax retirement plan, converting the whole amount in one tax year is likely not going to change your tax situation.

Is it beneficial for my kids if I do a Roth IRA conversion?

This is a question that some of the seniors with savings out there should be asking. If you’re 60+ years old and your life savings is primarily in pre-tax retirement accounts, converting some or all of that money may be beneficial based on your children’s income. If you have kids that make a lot of money, and eventually this money will be their inheritance, it is a good idea to start converting some or all of the pre-tax money. This way “The Man” doesn’t take more of your money after you are gone.

Beneficiary IRAs

In 2019, there were some significant changes to non-spousal beneficiary IRAs. These are the accounts IRA money goes into after an IRA owner passes away and leaves the money to anyone other than their spouse. The SECURE Act took away the option for those non-spousal beneficiaries to take withdrawals from the account over their lifetime.

Now if an IRA owner passes away and leaves the money to a non-spouse, that person has to withdrawal the money within the next 10 years. This could cause a serious amount of taxes to be owed on the withdrawals and dramatically increase those beneficiaries’ taxable income. This is especially true if they or their spouse is a higher income earner. Roth IRA conversion should be seriously considered in these situations.