Roth conversions, done deliberately

A Roth conversion moves money from a tax-deferred account into a Roth account, recognising the tax now in exchange for tax-free treatment later. The decision is about which year to pay.

The basic comparison

Convert if the rate you pay now is lower than the rate the money would otherwise face when withdrawn.

That comparison sounds simple and requires estimating a future rate, which depends on future income, future required distributions, future tax law and whether the money will be inherited.

What makes conversions attractive for many people is not a forecast of higher tax rates but a structural feature of retirement income: the years between stopping work and starting required distributions frequently have unusually low taxable income.

Converting during those years fills up low brackets that would otherwise go unused.

Why not converting has a cost

Leaving large balances in tax-deferred accounts sets up forced withdrawals later.

Those withdrawals arrive on top of Social Security and any other income, potentially in higher brackets, and they trigger the threshold effects discussed elsewhere on this site.

The result can be paying a higher rate on the same money simply because it was recognised in a worse year.

How much to convert

The standard approach is to convert an amount that fills the current bracket without crossing into the next.

Which requires knowing your projected taxable income for the year before converting, and doing the conversion late enough in the year that the estimate is reliable.

December is the common timing for this reason, though converting earlier in a year when markets are down has its own advantage — more shares are moved for the same tax cost.

The complications to check

Paying the tax. The tax should ideally be paid from outside the account. Using converted funds to pay it reduces the amount that receives Roth treatment and, if under the relevant age, may trigger a penalty on the amount withheld.

Health insurance subsidies. For those buying coverage through an exchange before Medicare, additional income from conversions reduces income-based subsidies.

The effective rate on a conversion in this situation can be far higher than the nominal bracket, and it frequently makes conversions uneconomic until Medicare begins.

Medicare premium surcharges. Income is assessed with a two-year lookback, so a conversion at sixty-three affects premiums at sixty-five.

This catches people who convert aggressively in the years immediately before Medicare enrolment.

The pro-rata rule. Where you hold both pre-tax and after-tax money in traditional IRAs, conversions are treated proportionally rather than allowing you to convert only the after-tax portion.

Irreversibility. Recharacterising a conversion is no longer permitted under current rules, so a conversion made on optimistic assumptions cannot be undone if the year turns out differently.

When conversions make particular sense

A market decline, since the same shares can be converted at lower value and the recovery occurs inside the Roth.

A year with unusually low income — a career break, a business loss, the first year of retirement.

Where a surviving spouse will face single filing thresholds, which are less favourable than joint ones, and where converting while both are alive spreads the recognition.

Where heirs are likely to be in high brackets, since inherited traditional accounts now generally must be emptied within a limited period.

When they do not

Where current income is already high and future income will be lower.

Where the tax would have to be paid from the converted amount.

Where the money is intended for charity, since charitable beneficiaries pay no tax on inherited traditional accounts, making the conversion pointless.

Where the conversion would cross a threshold with disproportionate consequences.

The multi-year view

Conversions work best as a programme rather than a single event.

A modest amount each year across the gap period generally produces a better result than a single large conversion, because it keeps each year's income within lower brackets.

Which means the planning horizon is the whole period from retirement to required distributions, examined as a unit.

General information only, not financial or tax advice. Rules and thresholds change — consult a qualified tax professional before converting.