Roth Conversion in Plain English

If you've spent 30 years putting money into a 401(k) or traditional IRA, you've been getting a tax break the whole time. But that break wasn't a gift. It was a loan, and the IRS expects to be paid back when you take the money out.

A Roth conversion is one way to decide when you pay that bill instead of letting the calendar decide for you. For people in their late 50s and early 60s, it's one of the most useful tax tools available, and one of the most misunderstood. Here's how it works, without the jargon.

What a Roth conversion actually is

A Roth conversion means moving money from a pre-tax account (like a traditional IRA or old 401(k)) into a Roth IRA. The amount you move gets added to your taxable income for that year, and you pay income tax on it.

After that, the money grows in the Roth, and qualified withdrawals later are tax-free. That includes the growth.

Think of it like this: your traditional IRA is a field of crops the IRS owns a share of. A Roth conversion is paying the IRS for its share of the seed now, so the whole harvest is yours later.

A few basics worth knowing:

• There's no income limit. Anyone with a pre-tax account can convert, no matter how much they earn.

  
  

• You choose the amount. You can convert a little or a lot, and you can do it once or spread it over many years.

  
  

• It's not a contribution. Converting doesn't require earned income and doesn't count against your annual IRA contribution limit.

  
  

Why would anyone pay taxes early?

It sounds backwards. Most of us spend our careers trying to pay less tax, not volunteering to pay it sooner. But a conversion can make sense when you expect your tax rate later to be the same or higher than it is today. Here's why that happens more often than people think:

• Required minimum distributions (RMDs). Once you reach your RMD age (73 for most people retiring now, 75 if you were born in 1960 or later), the IRS requires you to start pulling money out of pre-tax accounts every year, whether you need it or not. A large IRA can push you into a higher bracket in your 70s than you were in during your 60s.

  
  

• The widow's penalty. When one spouse passes away, the survivor usually files as single, with tax brackets roughly half as wide, while often keeping much of the same income. Roth money doesn't add to that tax bill.

  
  

• Your kids' tax bill. Most non-spouse heirs must empty an inherited IRA within 10 years, often during their own peak earning years. Inherited Roth dollars can generally come out tax-free.

  
  

• Flexibility. Roth IRAs have no RMDs for the original owner, and withdrawals don't count as taxable income. That gives you a bucket you can tap for a new roof or a big trip without bumping up your tax bracket or your Medicare premiums.

  
  

The sweet spot: your "gap years"

For many of the people we work with, the best window for Roth conversions opens the day the paychecks stop.

Picture someone who retires at 62 but waits until 67 or 70 to claim Social Security, and won't face RMDs until their 70s. In between, their taxable income can drop sharply, sometimes lower than it's been in decades. Those low-income years are a chance to convert money at a lower tax rate than they may ever see again.

The idea isn't to convert everything at once. It's to "fill up" a lower tax bracket each year, converting just enough to use the room you have without spilling into the next bracket. Done steadily over several years, this can shrink your future RMDs and smooth out your lifetime tax bill.

This is a big reason the years right after retirement matter so much. Decisions made in that window can shape your taxes for the next 25 years.

When a conversion may not make sense

Roth conversions get a lot of hype. They aren't right for everyone. A conversion may not be worth it if:

• You're in a high bracket now and expect a lower one later. Paying 32% today to avoid 12% tomorrow is a bad trade.

  
  

• You'd have to pay the tax out of the IRA itself. More on this below.

  
  

• You plan to leave your IRA to charity. Charities don't pay income tax on inherited IRA money, so there's no tax to save.

  
  

• You'll need the money soon. Conversions work best when the money has years to grow tax-free.

  
  

• Your pre-tax savings are modest. If your RMDs will be small and your income will be low anyway, the math may not favor converting.

  
  

Five traps to watch for

The concept is simple. The details are where people get hurt.

1. Paying the tax from the IRA. Ideally, you pay the conversion tax with money from a regular bank or brokerage account. If you withhold it from the IRA instead, less money lands in the Roth, and if you're under 59½, the withheld amount can also trigger a 10% penalty.

   
   

2. Medicare surcharges (IRMAA). Medicare Part B and D premiums are based on your income from two years earlier. A large conversion at 63 can raise your Medicare premiums at 65. It's not a dealbreaker, but it belongs in the math.

   
   

3. Health insurance subsidies. If you retire before 65 and buy coverage on the marketplace, your premium help is based on your income. A conversion can shrink or wipe out that subsidy.

   
   

4. The five-year rule. Each conversion has its own five-year clock. If you're under 59½ and withdraw converted money before five years pass, you may owe a 10% penalty.

   
   

5. There's no undo button. Since 2018, you can't reverse a Roth conversion. If the market drops the week after you convert, you still owe tax on the original amount. That's why many people convert in pieces rather than all at once.

   
   

The bottom line

A Roth conversion is really a question of timing: pay tax now at a rate you know, or later at a rate you don't. For many people heading into retirement, the gap years offer a rare chance to make that choice on their own terms.

The right amount to convert, if any, depends on your income, your Social Security plans, your health coverage, and what you want to leave behind. It's not something to guess at, and it's not something to do in a hurry at the end of December.

This article is for educational purposes only and is not tax, legal, or investment advice. Consult a qualified professional about your specific situation.

Investment advice offered through 55 Wealth, LLC, an Indiana-registered investment advisor. See our full disclosure at www.go55wealth.com/disclosure.