All good financial and tax planning addresses a fundamental question about individual retirement accounts (IRAs): traditional or Roth? Most advisors (us included) see a place for both traditional and Roth accounts. However, many of our clients don’t qualify to make Roth contributions, as their earnings are too high. So this conversation often evolves into a discussion of Roth conversions.

In this article, we’ll cover what Roth IRAs are, why they make sense, how conversions work, and the different ways we might discuss all of this in the broader context of your financial plan.

Traditional vs. Roth IRAs: The tax question

To understand why you might do a conversion, you first need to understand the difference between traditional and Roth IRAs:

The money you contribute to a traditional IRA is exempt from federal income tax when you contribute it; you pay income taxes on the money when you withdraw it from your account, usually in retirement. With Roth IRAs, you contribute money after taxes, but don’t have to pay federal income tax on the money when you withdraw it, usually in retirement. In both cases, the money grows tax free.

Most general financial education websites favor traditional IRAs over Roth IRAs for one key reason: Your income tax rate tends to be higher when you are working than in retirement. That means that you’ll pay less total income tax.

However, this logic ignores a few wild cards. First: It’s possible that income tax rates will change. It’s hard to say for sure that you will be subject to lower income tax rates in retirement. Second: Even if the total tax amount is lower in retirement, it may feel like more of a burden in retirement when you’re living on more of a fixed income.

Traditional vs. Roth IRAs: Everything else

First, you can’t touch the money in a traditional IRA (principal or earnings) until you turn 59 ½ without paying a penalty, except in certain circumstances outlined by the IRS. With Roth IRAs, however, you can tap into your original investment without paying any penalties, giving you greater access to your money.

Second, Roth IRAs don’t come with required minimum distributions (RMDs) like traditional IRAs do. This can be an especially important factor to consider if you plan to leave the money in your account to any heirs.

Roth IRAs often provide greater access and flexibility, both when you’re trying to build up a nest egg and as you get close to using it.

However, there are a few downsides. Because Roth IRAs must be contributed to with after-tax income, you pay income tax on the money that you convert. There are also income limits on Roth IRAs: If you make too much in a given year, you can’t contribute to a Roth IRA…if you contribute to it directly. 

There are other ways of contributing to a Roth account, namely contributing to a traditional IRA, then converting the balance into a Roth account. Converting a traditional IRA to a Roth IRA doesn’t come with an income limit, and you will pay income taxes on the amount you convert.

Because it’s a complex process, Roth conversions tend to work best when done as part of a broader financial and tax plan. There are certain times conversions make more sense and certain strategies to help minimize any potential tax burden.

When a Roth conversion makes sense

One of the many benefits of working with professional planners is that you don’t have to understand or execute strategies like a Roth conversion on your own. Still, there are a few concepts that can help you better understand when we might bring this strategy up and why.

Because you’re paying taxes on any money you convert, it often makes sense to convert a traditional IRA to a Roth IRA on years when your income tax rate is lower. If you have a year where you (or your spouse) lose a job, for instance, a Roth conversion may make sense, presuming the job loss isn’t a hardship.

Similarly, with a conversion, you don’t just pay tax on the principal you invested in the traditional IRA. You must also pay income taxes on any potential earnings, which would otherwise have grown tax free. If markets are having a down year (i.e., your investments have lost value), it may be a good opportunity for a conversion. If the amount you’re converting is smaller, so is your tax burden.

Finally, it’s important to note a very logistical when: Most tax-related rules around retirement accounts are tied to April 15 when taxes are due (versus December 31). Roth conversions are an exception: If you want to convert money to a Roth IRA, that conversion must be completed prior to December 31. This can be tricky as some people aren’t sure what their tax liability will be in a given year in early December when you’d want to initiate the process, but that’s something we can work through.

The Revo Financial strategy for Roth IRAs

We try to ensure our clients are diversified in terms of the type of investment accounts they have, not just what’s in those accounts. That means tax diversification: We want clients to have investments in tax-advantaged accounts, including both traditional and Roth IRAs, as well as taxable investment accounts, basic bank accounts, and more.

If you don’t have any money currently saved in a Roth IRA, we can discuss whether a conversion might make sense. Specifically, we can discuss potential conversions down the road if ever one of the potential triggers (like a job loss or a market downturn) should occur.