Welcome to NerdWallet’s SmartMoney podcast, where we answer your real-world money questions — in 15 minutes or less.
This week’s question is from Mike, who says: “I’m wondering about Roth conversions. My wife and I have about half of our retirement money in rollover or pretax IRAs. We’re also contributing to 401(k)s with our current employers. I’m wondering if we should convert any of our IRAs to Roth IRAs. Our federal tax bracket is relatively high. How do we decide if and when to do a conversion?”
A Roth conversion is when you transfer money from a regular retirement account, which is taxable in retirement, to a Roth IRA, which isn’t. Moving that money typically triggers a tax bill, so the big question you have to answer is whether paying the taxes now makes more sense than paying them later.
The general rule is that Roth conversions could be a smart move if you expect to be in the same or a higher tax bracket in retirement and you can pay the tax bill without raiding the account you’re converting (or any other retirement account, for that matter). Most people find their tax brackets drop when they retire. But if you’re early in your career and a good saver, or you think taxes will inevitably go up in the future, then a Roth conversion gets more attractive.
Normally, conversions make less sense the closer you get to retirement, but there are exceptions. If you’re in your 50s or 60s and have saved a lot, you could find yourself pushed into a higher tax bracket when you have to start taking withdrawals from your retirement accounts. These withdrawals are called “required minimum distributions” and they have to start at age 72. Sometimes it can make sense to do a Roth conversion, or a series of conversions, before age 72 to avoid that problem.
Roth IRAs aren’t subject to required minimum distributions, which means you can leave the money alone to grow if you don’t need it, or pass it tax-free to your heirs. And Roths give you more flexibility when you’re managing your tax bills in retirement. But there are other ways to get money into Roth accounts, such as contributing directly to a Roth IRA if your income is under certain limits, or contributing to a Roth 401(k) at work.
If you’re interested in doing a conversion, though, get expert help. The math can get tricky and you can’t undo a conversion, so talk to a tax pro or financial planner first.
Figure out if you’re a good candidate for a conversion. Roth conversions can make sense if you think you’ll be in the same or a higher tax bracket in retirement.
See if you have enough money outside your retirement accounts to pay the tax bill. Raiding the account you’re converting, or any other retirement account, changes the math to the point where a conversion probably doesn’t make sense.
Get expert help before you convert. The math can get complex and you can’t undo a conversion, so consult a tax pro or a financial planner first to make sure you know what you’re doing.
More about Roth conversions on NerdWallet
Sean Pyles: And I’m Sean Pyles. As always, be sure to send us your money questions. You can call or text us on the Nerd hotline at 901-730-6373. That’s 901-730-NERD. Or you can email us at [email protected], and you can also send us your voice memos to that email address.
Liz: Let’s get to this episode’s question, which is from Mike. Mike says, “I’m wondering about Roth conversions. My wife and I have about half of our retirement money in rollover or pretax IRAs. We’re also contributing to 401(k)s with our current employers. I’m wondering if we should convert any of our IRAs to Roth IRAs. Our federal tax bracket is relatively high. How do we decide if and when to do a conversion?"
Sean: Ah, the classic Roth conversion question. Just kidding. This is actually something that I haven’t answered before, but for those who are not complete money nerds like us at NerdWallet, Roth conversions are a pretty hot topic right now.
Liz: Tax law changes and current low tax rates have made Roth conversions attractive to a lot more people.
Sean: They have, but that doesn’t mean that they are any less confusing for most people. And I get how Roth conversions can seem like an additional layer of confusion in the already head-spinning process of retirement planning, but we have got your back. On this episode of the NerdWallet SmartMoney podcast, Liz and I are going to talk with investing and retirement Nerd Andrea Coombes to discuss what exactly a Roth conversion is, the advantages and disadvantages of it, and how to decide if it might be a good idea for you. Let’s get to it.
Liz: Hey, Andrea, welcome to the show.
Andrea Coombes: Thanks so much, Liz. It’s great to be here.
Sean: I’m so glad we can get your help answering Mike’s question, Andrea. Let’s just dive into it. Can you please set us up and explain in the simplest terms what a Roth conversion is?
Andrea: So a Roth IRA conversion is when you transfer money from a pretax retirement account, like a traditional IRA, into a Roth IRA. And anyone can do this. There’s no income limit and you can convert as much as you want, but there is one big caveat, and that is you’ll probably owe an income tax bill on the money you transfer.
Sean: You’re basically moving your retirement money from one kind of account to another kind of account, but the catch is that you’re going to have to pay a tax bill at the end? Why are people doing this, again?
Andrea: I know, right? Who wants a really big tax bill? But it can be worth it to get your money into a Roth. These accounts have some great advantages, especially when you compare them to a traditional IRA. So with a Roth, all of your money, including your interest and earnings, comes out tax-free in retirement. Plus with a Roth, there are no required minimum distributions in retirement. So if you don’t need the money, you can leave it in there, and you can leave the account tax-free to your kids or other heirs. Also, keep in mind that actually doing a conversion isn’t that hard. If you open a Roth account with an online broker, they can help walk you through the process of making a direct conversion from one account to the other.
Sean: Got it. So with a conversion, you do a little bit of work now and you pay some taxes now, but the idea is that it’ll pay off in a few decades when you’re saving money on taxes. I do have a question for you, though. Is this something that’s only for rich people, or can we commoners do this too?
Andrea: Happily, this is something even we commoners can do — like, actually anyone at all can do this. You can convert $100, you can convert $100,000, or more. If you think a Roth IRA is right for you, a conversion is something to look into.
Liz: Right, and by the way, having some money in a nontaxable account can be super helpful in managing your tax bill when you get to retirement. People put a lot of money into pretax because they love saving that money upfront. But then when the money has to come out, sometimes they’re trapped. They don’t have any source of income that’s coming from a nontaxable source. Financial planners call this tax diversification and they usually recommend it for most people. You can draw on the Roth without pushing yourself into a higher tax bracket or triggering higher Medicare costs.
Now, conversions aren’t the only way to get there. You can also contribute directly to a Roth IRA if you meet certain income limits. Also, if you have a Roth 401(k) at work, that’s another way to get money into a Roth. So if you don’t have the money to do a conversion right now or paying the tax bill now doesn’t make sense, you have other ways to get your money into an account that can be tax-free in retirement.
Sean: You guys have made this sound easy, smart and like a potential money saver, but I’m not totally sold. What should people be looking out for here?
Andrea: Well, there is that tax bill, so you’re paying taxes years or possibly even decades earlier than you have to. That can make sense if your tax bracket when you retire is going to be the same or higher than it is now, but if your tax rate goes down in retirement, a conversion now could cost you more in taxes than you’d pay later.
Sean: That sounds like a bit of a gamble. How am I supposed to know what my tax rate’s going to be 20, 30 years from now?
Andrea: Wait, Sean, you don’t know your future tax rate? I can’t believe that.
Sean: I wish.
Andrea: Just kidding. It’s impossible to know for sure, but you can make an educated guess. So if you’re early in your career, the chances are good you’ll probably face higher taxes down the road as you move through your career. If you’re closer to retirement, it’s important to look at your expected income sources in retirement and estimate what your likely tax rate will be. Also, it’s important that you’re able to pay the taxes on a Roth conversion from a savings account or your current income, really any source other than your retirement account or any retirement account. Otherwise, the math really doesn’t work.
Sean: It seems like the earlier on in your career you are, the more this could make sense mathematically, because you’ll have less money in your account and then you’ll have to pay less taxes on that. Is that right?
Liz: Yeah, that’s basically how it works. Now, normally, Roths make less sense the closer you get to retirement, but even then there are some exceptions. If you’re in your 50s and 60s and you have a lot of money in retirement accounts, you could find yourself in a higher tax bracket once you have to start making those required minimum withdrawals, which now have to start at age 72. So doing some conversions could make sense, but the math is kind of tricky.
Andrea: That is so true, Liz. And it really makes sense to talk with a tax pro or a financial planner to make sure you don’t make a mistake, like accidentally bumping yourself into a much higher tax bracket. And one thing a tax pro or a planner might suggest is a series of conversions. So that means instead of converting all at once, you convert in pieces. It’s sometimes called filling out your tax bracket. So, for example, say your other income puts you maybe $10,000 below the next highest tax bracket. In that situation, you’d convert $9,999 and keep yourself within your tax bracket, and that gets money into a Roth without pushing you into a higher tax bracket. But again, you really want to talk to a professional when doing this, just to make sure you do it right, because if you make a mistake, you’re stuck. You used to be able to undo a conversion, but that is no longer possible.
Sean: If you are anything like me and your head is spinning a little bit just from hearing those numbers, or if you’re just considering this at all seriously, do talk to a professional. It’s pretty serious stuff, and you don’t want to make a mistake that you can’t undo here. But one thing I’m also wondering about, it does seem like I’ve been hearing about conversions more and more. Why do you guys think that conversions might be gaining in popularity?
Liz: Well, Congress lowered tax rates starting in 2018, and a lot of those changes are going to expire in 2026, so people are thinking they might want to convert now since their tax rates might be higher in the future. Also, Congress changed the rules again late last year. They took away something called the stretch IRA, which was a strategy that affluent investors used to pass tax-advantaged money to their heirs. So now some are doing conversions instead. What that basically boils down to is the rich folks are doing the conversions so that they pay the taxes and then the money goes tax-free to their heirs.
Andrea: I’d also note that I think Roth IRAs in general are more popular right now. I think more people know about them, their popularity has grown, and a lot of that has to do with just the uncertainty around taxes. So with a Roth you really eliminate tax uncertainty, because you pay that tax bill and then you don’t have to worry about it going forward. So I think that is another reason maybe that these are quite popular.
Sean: People want to get it while the getting is good and take advantage of recent changes that have made this more appealing.
Liz: I think that tax rates have a lot to do with it, so it’s, I think, being driven in part by that. So the answer to your question, Mike, is a big old maybe. A lot of times a Roth conversion can make sense. Other times you’re paying taxes when you don’t need to, or you’re paying them earlier than you need to, in any case. So this is a great question to ask a tax pro or a financial planner. They can walk you through the process and also talk to you about the potential implications now and in the future.
Sean: While we aren’t the CPAs or financial planners that can give you a definite yes or no on this question, Mike, I hope that we provided some good background to help you think through this question. And thank you, Liz, thank you, Andrea, for all of your great insights. I think that is all we have for this episode. Let’s get to our takeaway tips. First up, Roth conversions can make sense if you think you’ll be in the same or a higher tax bracket in retirement.
Liz: And you have to be able to pay the taxes on the conversion without raiding the account you’re converting or any other retirement account.
Sean: Lastly, you will want to get some expert help if you’re seriously considering this, because the math can be pretty tricky and conversions cannot be undone. And that is all we have for this episode. Do you have a money question of your own? Turn to the Nerds and call or text us your questions at 901-730-6373. That’s 901-730-NERD. You can also email us at [email protected], and you can even send us your voice memos to that email address. However you want to send us your questions is just fine. Also, visit nerdwallet.com/podcast for more info on this episode, and do remember to subscribe, rate, and review us wherever you’re getting this podcast.
Liz: And here’s our brief disclaimer, thoughtfully crafted by NerdWallet’s legal team: Your questions are answered by knowledgeable and talented finance writers, but we are not financial or investment advisors. This Nerdy info is provided for general educational and entertainment purposes and may not apply to your specific circumstances.
Sean: And with that said, until next time, turn to the Nerds!