Weighing a Roth Conversion? Don’t Overlook These Five Issues

A piggy bank has a strip of paper coming out of its slot that says Roth IRA.

(Image credit: Getty Images)

By Daniel Rey, Investment Adviser Representative

published 2 November 2023

Most investors understand that they need diversification in their portfolios. As a result, they are fairly good about settling on a mix of aggressive, moderate-risk and low-risk investments.

But one area people often fail to account for — especially when saving for retirement — is diversification of the tax status of their assets. Take a look at the retirement accounts of many Americans, and you will likely see they are heavily weighted toward IRA, 401(k), 457 and 403(b) accounts. People rely on that savings for their retirement income, along with Social Security and perhaps a pension.

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Of course, one astute way to mitigate that tax risk is to convert pre-tax dollars to tax-free dollars. And a popular strategy for doing that is to convert a tax-deferred account to a Roth IRA. Unlike with a traditional IRA or other tax-deferred account, you don’t pay taxes when you make a withdrawal from your Roth account because it’s not considered taxable income (provided you follow the Roth IRA distribution rules).

You’ve likely heard that too much of a good thing can be a bad thing. That sometimes applies to a Roth conversion. If you are at an age where you are anticipating signing up for Medicare — or you are already there — you need to be cautious about how much of your retirement savings you convert to a Roth in a given year. This is because the cost of your Medicare Part B premium is determined based on your modified adjusted gross income from two years prior.

Yes, your Social Security benefits can be taxed. In fact, up to as much as 85% of your Social Security benefit is potentially taxable. Your provisional income is what determines whether and how much of your Social Security is taxed. Provisional income is the total of half of your Social Security benefit, plus your tax-exempt interest, plus the other sources of taxable income that make up your adjusted gross income, including pensions, wages and dividends. If your provisional income is:

It’s important to know that there are stipulations for accessing the money in your Roth tax-free. You can withdraw the contributions you make to a Roth IRA at any time, whatever your age, without owing taxes or a 10% early-withdrawal penalty. But to withdraw any earnings tax-free and penalty-free, you must be at least 59½, and you must have waited at least five years after opening a new Roth account.

With tax-deferred accounts, such as traditional IRAs, 457s, 403(b)s or 401(k)s, you must start withdrawing a certain percentage when you reach age 72 (or 73 if you reach age 72 after Dec. 31, 2022), whether you want to or not. This is called a required minimum distribution, or RMD, and it is fully taxable. But there is no RMD for a Roth. You can leave the money untouched as long as you like if other income is taking care of your needs. Also, an additional benefit is that you can pass the Roth account to your family after you die, tax-free.

Clearly, there are plenty of reasons to consider a Roth conversion in your personal plan, but as you can see, how well it will work for you depends on variables such as your income, other assets and your goals. Your financial professional or tax planner can give you guidance on how to responsibly approach a conversion for your specific situation — and get some tax diversification in the process.

Disclaimer

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

Daniel Rey is the founder and CEO of Central Florida-based Voyage Retirement Solutions. Daniel developed the Retirement Navigator, a proprietary planning process designed to help Voyage's clientele achieve their long-term financial goals. He is passionate about helping investors, from public pensions and other employee retirement benefit plans to individual retirement planning.