When Is a Roth Conversion a Good Idea?

Transcript

When should I consider doing a Roth conversion? It's a great question, and I often find people get confused by it. The confusion stems from the difference between a Roth contribution and a Roth conversion, two different things. Here we're talking about Roth conversions. So if you've heard about Roths, or someone's mentioned Roth conversions before and you're unsure if this matters for you, you're not alone. Roth accounts can be incredibly powerful, but Roth conversions done at the wrong time can cost you more in taxes than they save. I'm Nick George, a certified financial planner and founder of ClearMind Capital, and I want to walk you through when Roth conversions do make sense, when they don't, and how to think about them the right way without guessing.

Before we even talk about when to convert, let's talk about why people consider Roth IRAs in the first place. A Roth IRA has three big advantages. The first is the money grows tax-free forever. Once you put money inside a Roth account, it's out of the tax system forever. Second, Roth IRAs don't require the money to be forced out later in life, unlike traditional IRAs or pre-tax accounts. We call those required minimum distributions. The IRS has them on pre-tax accounts because they eventually want their tax money, and the way they get it is by forcing you to withdraw from the traditional IRA. Roth IRAs don't have this, so it gives you more control. Third, Roth withdrawals don't increase your taxable income. This is super important in retirement because it gives you control and flexibility. We're really piggybacking off one and two, but this matters for things like Medicare premiums and overall tax planning in retirement.

So when do Roth conversions make sense? Let's start with the biggest one: in years where your taxable income is lower. Here's why that matters. When your income is lower, your tax rate is lower, so Roth conversions are taxed at a lower rate if we do them in those years. For many people, this happens in the early years of retirement. Why? Because their paychecks have stopped, Social Security probably hasn't started yet, required minimum distributions haven't begun, and they may be living off cash or savings. This creates a tax window. So instead of waiting and letting your entire IRA be taxed later, possibly at higher rates, you can move some money over now at lower rates. And we don't have to do it all at once. This is not an all-or-nothing strategy. You can convert partial balances, as much or as little as you want, so we may strategically convert just enough to fill lower tax brackets.

Number two, when markets are down. This one is harder to predict, but very powerful when used correctly. If the market drops and you convert during that time, you're paying tax on a temporarily lower account value, and temporarily is key. Here's a simple way to think about it. If your IRA was worth $50,000 and the market drops so it's now worth $40,000, converting at that point means you're only paying tax on $40,000, not $50,000. When the market eventually recovers, that long-term growth now happens inside the Roth, where it's tax-free. This only works if Roth conversions are part of your long-term plan. I am not recommending a blanket strategy of "whenever the market drops, convert." That's not what I'm doing here. This is mainly if you're already planning to convert in a year, and all of a sudden the market is down, then let's go ahead and do it then rather than wait.

Third, years with large deductions. Sometimes there are years with unusually high deductions, like from charitable gifting, large medical expenses, or other deductions in general, and these can help offset Roth conversions.

So we know Roth conversions make sense in years where taxable income is projected to be lower, when the market is down, and in years with large deductions. When don't they make sense? This part matters just as much. The first might be obvious: in years where you have higher income, your peak earning years. If you're already in a high tax bracket, converting now makes little sense when we can wait for those early retirement years and strategically do it then.

Number two, before you have a real plan, and I'm serious about this. Roth conversions should never be done in isolation, meaning you should never do it on a whim just because you think you should. You really need to understand your income today, your projected income later, when Social Security starts, when RMDs begin, and how it all fits into your overall plan and balance sheet. There's just a lot to think about with retirement accounts, and with retirement in general. When you're working and accumulating, you're really just trying to invest and protect. In retirement, there are so many moving parts it can become overwhelming fast.

Third, it might not make sense if you live in a high-tax state like California or New York but you plan to retire to a no-income-tax state like Florida or Texas. Why do Roth conversions while you're living in the high-tax state when you can wait and do them in the no-tax state?

So here's the bottom line. Roth conversions aren't about "Roth is always better." It's about tax planning and reducing your total lifetime tax bill, not just this year. I say that all the time. The goal is to reduce your total lifetime tax bill, not your annual tax bill year after year. That is just not a winning strategy. When done well, Roth conversions can save tens, and sometimes hundreds, of thousands of dollars over retirement.

This is what we do all day, every day. We really try to help bring clarity to people nearing retirement and help them sort through these decisions and gain a sense of confidence in their next chapter. It's a chapter we want to get right. If you're not sure where to turn, we'd love to meet you. We'd love to have a one-on-one conversation just to see what you have going on and how we can help. No pressure, just here to be a resource for you. Have an awesome day.

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