Picture this: You’re enjoying a summer BBQ, basking in the aroma of sizzling burgers, when your know-it-all neighbor Bob starts waxing poetic about Roth conversions. He’s rattling off about tax benefits and required minimum distributions (RMDs)—but you know there are some potential issues he’s not talking about. Suddenly, you find yourself embroiled in the financial equivalent of a Shakespearean drama—to Roth or not to Roth?

To answer that, let’s dive into the world of Roth conversions. This blog covers what a Roth conversion is, why you might want to do one, and the potential pitfalls to be aware of.

What a Roth Conversion Is

A Roth conversion is the process of moving your retirement savings from a traditional retirement account, like a 401(k) or IRA, to a Roth IRA. Think of it as switching your morning coffee from a regular brew to a latte with extra foam—there are benefits. But some costs might leave a bitter taste if you’re unprepared.

One benefit? Since Roth IRAs are funded with post-tax dollars, the money you withdraw during retirement is typically tax-free.

Also, unlike traditional IRAs, Roth IRAs don’t have RMDs. No obligatory withdrawals mean you can decide when and how much money you pull out. You can even pass on these funds to your heirs tax-free.

Sounds great, right? But there are a few potential gotchas.

The Potential Negative Effects of Roth Conversions

If you’re unprepared, Roth conversions can hit you with the tax equivalent of a cold shower. When you convert to a Roth IRA, you need to pay income taxes on the converted amount that year. So, if you have a beefy traditional IRA you’re converting, you could end up with a painful tax bill.

Let’s say you’re in the 24% tax bracket and decide to convert $100,000 from your traditional IRA to a Roth IRA. That conversion could slap you with a $24,000 tax bill for that year, so you’ll need to make sure you have the funds set aside to pay Uncle Sam.

Moreover, the converted amount adds to your income for the year, potentially propelling you into a higher tax bracket. What’s more, a higher income from the conversion could increase your modified adjusted gross income (MAGI), potentially affecting certain tax credits, deductions, and Medicare premiums for Parts B and D.

So, how do we sidestep these financial landmines?

Strategies to Avoid Roth Conversion Pitfalls

Timing is everything in Roth conversions. One strategy to soften the tax blow is to plan your conversion in a year when your income is lower.

Say, for instance, you’re taking a sabbatical, switching careers, or experiencing a business slump. While these scenarios might not sound ideal, they could have a silver lining when it comes to Roth conversions. A lower-income year may drop you into a lower tax bracket, meaning you’d owe less in taxes on the conversion.

On to a second strategy: partial Roth conversions. You spread the conversion over several years, converting only a portion each year and helping to manage the tax implications.

For example, if you have $100,000 in a traditional IRA, instead of converting it all at once and getting hit with a hefty tax bill, you could convert $20,000 per year over five years. This could keep you from jumping into a higher tax bracket and spreading the tax burden over a half-decade.

You might also consider working with a fee-only, fiduciary financial advisor. Fee-only advisors aren’t racking up commissions on selling financial products. As fiduciaries, they must act in your best interest as they help you navigate the labyrinth of Roth conversions.

The right advisor can help you determine whether a Roth conversion is a good move for you, considering factors like current income, future tax expectations, and retirement goals. They can guide you on the when, why, and how, helping you to align your decisions with your goals and to avoid any painful repercussions.

Our fee-only, fiduciary wealth management firm helps clients determine whether Roth conversions are right for them as part of their ongoing financial planning and investment management.

Schedule a complimentary consultation with one of our fee-only financial planners to discuss your personal situation.

This material was generated using artificial intelligence (ChatGPT) and edited by Kaleido Inc. from information derived from sources believed to be accurate. This information should not be construed as investment, tax, or legal advice.