Retirement Read Time: 7 min

The Three Tests of a Roth Conversion

 Tim Steffen, Director of Advanced Planning

It’s not hard to understand why Roth IRAs are popular – who wouldn’t want to build up a savings account that can provide tax-free income during retirement? But contributing to a Roth can be difficult to do as it requires compensation income, and total income that falls under a certain threshold. Fortunately, there is a second way to fund a Roth IRA – the Roth conversion.


A Roth conversion simply means withdrawing, or converting, funds from your Traditional, pre-tax retirement savings account, like an IRA or 401k, and moving them to the Roth accountv.  Doing a conversion does mean you have to pay upfront tax on the amount converted from the original savings account, but once it’s moved to the Roth account, any growth inside the Roth can be withdrawn completely tax-free, as long as you follow a few basic rules.  And anyone can do a Roth conversion, regardless of age, income level or work status.  As long as you have an existing retirement account, those funds can very likely be converted to a Roth account.

But doing a Roth conversion can be an expensive proposition.  Remember that a Roth conversion is really a choice to pay tax on your retirement savings today, in exchange for tax-free growth for the future. Because of this up-front tax cost, you need to carefully evaluate whether a Roth conversion is really in your best interest. 

At Baird, we help individuals analyze a Roth conversion strategy by focusing on three key tests:

  • How are you going to pay the tax cost?
  • How does that tax cost today compare to what it would be in the future?
  • And how soon are you going to need those dollars after the conversion?

Test One: How will I pay the upfront tax?

When you withdraw the funds from your IRA or 401k to do the conversion, you can certainly hold some of that amount back to cover the tax you’re going to owe on the conversion. Ideally, though, you would use savings from outside your IRA or 401k to pay that tax, allowing you to get as much as possible into the Roth and growing tax-free.  This is especially true if you’re under age 59 ½ at the time of the conversion.  Up until that age, any amount you withdraw from your IRA that doesn’t go to the Roth will be considered an early withdrawal and is likely to be subject to an extra 10% tax penalty.

Now, if you have to use IRA dollars to pay the tax on the conversion, it doesn’t necessarily mean a Roth conversion won’t be a good strategy.  It just means it is going to take longer for the benefits of the Roth to become apparent, but as you’ll read later, time is often the best thing you have going for you with a Roth conversion.

Test Two: How does my current tax rate compare to my future tax rate? 

In a perfect world, you would do a Roth conversion when your tax rate on the conversion will be less than when you withdraw those funds in retirement. One of the best times to convert IRA dollars to a Roth is during what we refer to as “the trough years” – the period after you’ve retired but before you collect Social Security benefits, or you’re subject to the required minimum distribution rules.  During that time, you usually have complete control over the amount and source of income you generate, so managing the tax cost of a conversion can be much easier.

It's impossible to predict what tax rates are going be just a couple of years from now, let alone perhaps decades from now for those who convert at younger ages.  So maybe rather than trying to predict tax rates, look at your income level.  If you’re someone who is well advanced in their career, you might be at your peak earnings level right now.  Adding conversion income on top of that might come at the highest tax cost you’ll ever experience.  Instead of converting then, consider making the conversion after retirement, when your wages have gone away and you can begin taking advantage of the lower marginal tax brackets again. 

As we said earlier about how you pay the tax, paying a higher tax cost today than you might in retirement doesn’t necessarily mean a Roth conversion is a bad strategy.  It can make it a lot harder to justify the conversion, but once again – time can be your friend when it comes to making the best use of a Roth conversion.

Test Three: When do I plan to withdraw?

Our third and final test is perhaps the most important, and it goes back to our earlier points about time.  How long can you leave the converted amount in your Roth account before you need to withdraw from it?

The general rule is – the longer you can leave money inside the Roth after doing a conversion, the more effective the Roth conversion will be.  You need to give the Roth enough time to grow tax-free and overcome that initial tax drag. While ideally you would not use IRA dollars to pay the tax on the conversion, and not convert when your tax rate is higher than it would be during retirement, both of those can be overcome by letting the Roth account grow tax-free for as long as possible.

Now, that time frame might be longer that you’re able to wait, and in some cases it might even mean your heirs are more likely to benefit from the conversion than you are. But that can be okay. In fact, the most effective conversions are those done with dollars you’re never going to need in retirement. You pay the tax on those savings now, and then you never have to touch them again, giving you years – perhaps decades – of tax-free accumulation.

Other considerations

Now to be fair, there are other things we consider with a Roth – such as fact they’re not subject to RMDs, or that they can serve almost like an emergency fund for unexpected expenses in retirement. And there’s an estate planning angle to conversions, as it may make more sense for you to pay the tax on your retirement savings than your kids or grandkids.

All of this highlights the layers of considerations that should be taken before a Roth conversion. Fortunately, our team has the tools and expertise to weigh the pros and cons of a Roth conversion in the context of your particular needs and situation. We encourage you to give your advisor a call to evaluate the opportunity.

The information reflected on this page are Baird expert opinions today and are subject to change. The information provided here has not taken into consideration the investment goals or needs of any specific investor and investors should not make any investment decisions based solely on this information. Past performance is not a guarantee of future results. All investments have some level of risk, and investors have different time horizons, goals and risk tolerances, so speak to your Baird Financial Advisor before taking action.

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