Roth IRAs have made a good run in their relatively short 23-year history. I join with millions of Americans in celebrating the fact that there is a tool like this, allowing workers to save and grow their after-tax dollars and never pay taxes on them again. It’s fitting that the creation of the Roth IRA fell under the Tax Relief Act of 1997.

Roth IRAs have many advantages (which I’ll highlight again); but what I’d really like to dive into is something called a Roth Conversion--where you convert traditional IRA funds into Roth IRA funds.

I’ll first recap the advantages of Roth IRAs over Traditional IRAs, then explain how Roth Conversions work and the potential tax savings, and wrap up discussing when Roth Conversions makes the most sense.

Roth IRAs versus Traditional IRAs

First, a quick refresher of the advantages of Roth IRAs, and how they compare to Traditional IRAs, especially in the context of doing a Roth Conversion.

Roth IRA funds are withdrawn tax-free, Traditional IRA funds are not

The obvious advantage of Roth IRAs is you can pay your taxes up front, and receive tax-free growth and withdrawals into the future. This makes Roth IRAs particularly appealing to those who may be in their lower earning years (e.g., young college grads) or those who find themselves earning less mid-career (e.g., career changer).

Traditional IRA contributions are paid with pre-tax dollars, so while they grow tax-deferred you’ll eventually owe taxes when you take the money out.

The assurance that your taxes have been paid and you don’t have to worry about the impact of future tax changes can be a big benefit of Roth IRAs.

Roth IRAs allow withdrawal of your basis without penalty, Traditional IRAs do not

While you cannot take out the amount of money that’s grown in your Roth IRA, you are allowed to withdraw your basis, or the money you’ve contributed to the account. Other tax-advantaged retirement accounts will demand a 10% penalty for this withdrawal if taken before age 59 ½, but not the Roth IRA.

For example, if you’ve contributed $50,000 to your Roth IRA over the last 10 years and the total account value is $75,000, you can take out your basis of $50,000 anytime and for any purpose. Withdrawing any amount above $50,000 (i.e., your gains) will result in a 10% penalty on the withdrawn gains, assuming you haven't reached age 59 ½ . Keep in mind your Roth IRA account needs to be open for at least 5 years before withdrawing your basis.

This access to Roth IRA basis presents a flexible, readily accessible source of cash.

Stretch Roth IRAs create tax-free wealth for your heirs, Traditional Stretch IRAs do not

A Stretch Roth IRA can be used to pass Roth IRA wealth on to your heirs. Remember, that’s tax-free money! Not only do you benefit from these tax-free funds, but your heirs can benefit as well. By inheriting your Roth IRA, your heirs are required to make minimum distributions from the account, but over what length of time those distributions are made is typically determined by the age of the beneficiary inheriting the Roth IRA.

For example, assume your mother passes away with a Roth IRA valued at $200,000, leaving it all to you. Once you become the account owner of the Roth IRA (now an Inherited Roth IRA), you are required to take distributions; however, those distributions are determined by your life expectancy, not your mother’s. If you’re 40 years old and are expected to live until age 85, you’ll have 45 years of tax-free distributions on what’s withdrawn, and tax-free growth on the remaining balance!

Until recently, Stretch Traditional IRAs followed similar rules; however, the recently passed SECURE Act changed the law for Stretch Traditional IRAs. Now, these funds must be taken out by their heir(s) entirely within 10 years, paying taxes on every withdrawal at their current marginal tax rate.

How Roth Conversions Work

So we now know some of the benefits of Roth IRAs (if you didn’t already), but how do Roth Conversions work and why are they so effective?

First, the concept of a Roth Conversion is very simple. You’re taking traditional IRA funds and turning them into Roth IRA funds by paying the taxes now, rather than waiting to pay them later. Why would someone do this? The most common scenario is when you are in a lower marginal tax rate now than you expect to be in the future.

For example, consider a couple where the wife is currently the only wage earner in the family. She and her husband are planning to retire when they both reach age 70, at which time they’ll both start collecting Social Security. Two years later, they will start taking required minimum distributions (RMDs) from their traditional IRA accounts, and she’ll start collecting her pension as well. This situation of two Social Security checks, combined with RMDs and a pension could easily put them into a higher tax bracket in retirement than they are currently. To take advantage of this low income tax situation, they could convert a portion of their traditional IRA into a Roth IRA.

The chart below shows a visual illustration of this concept. In this example, the green area represents periods of earned income. Notice the drastic drop in income around age 64, and the subsequent jump in income at age 70. Notice also that the income continues to climb with RMDs starting at age 72.

Through a Roth Conversion, this couple could pay taxes now and “fill up” those very low tax brackets, rather than waiting to withdraw their funds at higher tax brackets. The tax brackets in this illustration may be difficult to see, but the Roth Conversion example below shows taxes being paid between the 10% to 15% tax brackets, rather than the 25% to 28% tax brackets.

In other words, this sample Roth Conversion reduces the taxes owed on the converted funds by half, AND allows those funds to continue to grow tax-free!

Roth Conversions in Summary

Remember a few key points for why Roth Conversions can be so effective.

By paying taxes now, you can potentially decrease your overall tax liability by avoiding paying taxes when you’re in higher tax brackets.
With Roth IRAs there are no RMDs (not until they become inherited anyway). This creates tax diversification and lets you more tactfully choose the best time to receive this tax-free income.
Roth IRAs that pass to your heirs become Stretch Roth IRAs, giving your heirs tax-free income when they take withdrawals, and tax-free growth on the funds remaining in the Roth IRA.
Roth Conversions make the most sense when you’re at a relatively low marginal tax rate compared to the future. For many savers, this is particularly true right around retirement when your income drops, but before your Social Security and RMDs kick in.

I hope this article has been helpful for you. Roth Conversions can be a powerful tool to potentially decrease your overall tax liability by paying taxes on your IRA funds at more opportune times, rather than waiting until later when you’re forced to. With Roth IRA funds in hand following a conversion, you can enjoy the benefits Roth IRAs present, including withdrawing your basis without penalty, tax-free growth for you and your heirs, and tax-free withdrawals for you and your heirs as well.