Key takeaways
- A Roth conversion means moving money from a traditional retirement account into a Roth IRA, where you pay taxes now in exchange for tax-free qualified withdrawals.
- It can be a smart move in several scenarios: your income exceeds the eligibility limits for IRAs, you want lower required minimum distributions in retirement, you’re planning an early retirement, or you’re temporarily in a low tax bracket.
- Done right, a conversion can lead to savings over time, but timing and tax planning matter enormously. We recommend working with a financial and/or tax specialist before converting.
- Households with over $100k at Betterment can kick the tires on a Roth conversion with the help of a professional.
Roth IRAs and their tax-exempt perks are pretty great—so great that in some scenarios, it can make sense to convert pre-tax dollars from traditional IRAs and 401(k)s into post-tax dollars in a Roth IRA.
This is what’s known as a Roth IRA conversion. You’re taking those pre-tax funds and telling Uncle Sam you’d rather pay taxes on them now in exchange for the benefit of tax-free qualified withdrawals down the road.
So what scenarios are Roth conversions ideal for? Four in particular:
High earners and the “backdoor” Roth conversion
Did you know the IRS restricts access to Roth IRAs based on income? Shut the front door!
Yes, if your income exceeds these limits, you can’t contribute directly to a Roth IRA. But as the saying goes, when one door closes, another door opens. A “backdoor,” more specifically.
A “backdoor” Roth entails contributing after-tax dollars first to a traditional IRA, then converting those funds to a Roth IRA. It’s fairly straightforward in two scenarios:
- You’ve never contributed to a traditional IRA before. Betterment makes it easy to not only open both a traditional and Roth IRA, but to convert those traditional funds with only a few clicks.
- You’ve made only pre-tax contributions to a traditional, SEP, and/or SIMPLE IRA(s). Thanks to the IRS’s pro rata rule, you’ll need to first move those pre-tax dollars out of their respective accounts and into a traditional 401(k) or 403(b) before you can use the IRA for a backdoor.
Now, things can get tricky if you have a mix of both pre- and post-tax funds in any traditional IRAs (Side note: the IRS treats any and all traditional IRAs you have as essentially the same bucket).
So before going down the road of a backdoor Roth, or any Roth conversion really, we highly recommend seeking out both financial and tax guidance.
In the case of the former, households with $100k at Betterment can get free guidance on a backdoor Roth via live chat. Already a customer and clear that mark? You’re already in—just open a chat.
Considering making the move? Our Licensed Concierge team is here to help.
Recent retirees and unwelcome RMDs
The IRS doesn’t let you keep pre-tax funds in your traditional IRAs and 401(k)s indefinitely. Those dollars are meant to be spent, after all. And Uncle Sam wants (or needs) that tax revenue at some point.
So starting in your 70s (75 for those born after 1960, 73 for those born 1951-1959), annual required minimum distributions (RMDs) from these accounts kick in, and the withdrawals are taxed accordingly.
RMDs aren’t inherently a bad thing, but if your expenses can already be covered from other sources, RMDs can needlessly raise your tax bill.
You can get ahead of this and lower your future amount of RMDs by converting traditional funds to a Roth IRA, which is exempt from RMDs, before you reach RMD age.
This can be especially beneficial when your income is low and you have extra space in a low tax bracket you can take advantage of. Another benefit is you’ll minimize taxes on Social Security benefits and Medicare premiums later on in retirement.
Early retirees and the Roth conversion “ladder”
If you want to retire early, even by just a few years, you might encounter a problem: Most of your retirement savings are tied up in tax-advantaged 401(k)s and IRAs, which slap you with a 10% penalty if you withdraw the funds before the age of 59 ½.
A few key exceptions to this early withdrawal rule exist, however:
- Regular contributions to a Roth IRA (not the growth from those contributions) can be withdrawn any time without taxes or penalties.
- Once regular contributions are exhausted, Roth IRA conversions can be withdrawn penalty-free as well provided you let each conversion sit for at least five years.
So with a little advance planning, early retirees can create a “ladder” of penalty-free Roth IRA funds. They convert funds each year, pay income taxes on them at that time (or not, if they play their cards right), wait five years, then withdraw each conversion scot-free.
People experiencing temporary income dips
Say you find yourself staring at a significantly smaller income for the year. Maybe you’re taking some time away from work, or you work on commission and had a down year.
Whatever the reason, that dip in income means you’re currently in a lower tax bracket, and it may be wise to pay taxes on some of your pre-tax investments now at that lower rate compared to the higher rate when your income bounces back.
Roth conversions can be powerful, but plan carefully
If you find yourself in one of these scenarios, a Roth conversion could be a real opportunity for you. But the difference between a smart conversion and a costly one often comes down to timing, tax planning, and knowing the rules.
Before you pull the trigger, it’s worth reading up on the most common Roth conversion mistakes—and even better, talking it through with an advisor who can look at your full picture. Betterment Premium gives you access to a team of CERTIFIED FINANCIAL PLANNER® professionals who can help you figure out the right amount to convert, in the right year, for your situation.
