What is a Roth IRA Conversion?

A Roth IRA conversion takes the assets from a regular IRA and converts them into a Roth IRA by paying taxes on the account’s gains and pretax contributions. The assets moved to a Roth IRA will be included in your taxable income the year the conversion occurs, at ordinary income tax rates (with no capital gains breaks). Once converted, there will be no more taxes to pay (ever) and the useful features of a Roth account will be available.

In a Roth account the earnings from your investments are tax-free as long as you have the account for at least 5 years and are over 59 ½ years of age. The withdrawal process is easy; money can be taken out at any time with no minimum withdrawal requirements or penalties. In combination these features can be used to manage your overall income tax bracket. Assets in a Roth IRA account are also great for estate planning, as you essentially pre-pay taxes for your beneficiaries. Finally a conversion offers a back doorway for higher earners to pick-up a Roth account that they would not otherwise be able to open because of restrictions around earnings (Roth accounts cannot be opened or contributed to once above a certain income level).

Conversions are not, however, for everyone and timing is important. The primary objective is to minimize taxes paid on the conversion. A significant drop in the stock market is one trigger because it will temporarily reduce the size of unrealized gains. The other important dimension would be converting during a year that current income-tax liability is reduced. This might, for example, occur through the sale of a rental property that resulted in a large loss. Conversions don’t usually make sense for those in high tax brackets; better to defer and gather the cumulative benefits then pay the taxes when your tax rate drops in retirement (which it does for most people).