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Roth Conversions 101

As 2022 begins to fade and we prepare for the holidays and new year, it is an excellent time to start making end-of-the-year decisions to better position yourself for 2023. One such activity includes considering a Roth conversion in your tax-deferred retirement accounts.

What is a Roth conversion?

A Roth conversion involves converting pre-tax money in a retirement account such as the traditional IRA, SIMPLE, SEP, or 401k) and moving it into a post-tax retirement account, such as the Roth IRA or Roth 401(k). Hence the name Roth conversion, since one is recasting the tax designation of the monies moved.

The benefits

Why would someone want to convert tax-deferred monies? Simply put, to lock in a lower tax bracket and hedge against the future.

When you are in a lower tax bracket now than you expect in the following year or retirement, doing a Roth conversion can make sense for your cents. The reason is that you can convert any amount to the tax rate you desire.

Further, with inflation and government debt ever increasing, there is a distinct possibility that taxes will increase. By converting to Roth dollars now, you remove the uncertainty and lower the amount you must withdraw in retirement once you reach the required minimum distribution (RMD) age of 72.

In addition to these two benefits, those who convert pre-tax dollars to Roth can withdraw the funds after five years without incurring the standard 10% early withdrawal penalty assessed on pre-retirement distributions.

Lastly, for those who can contribute after-tax dollars to their 401k plan or are disqualified from tax-deductible IRA contributions, after-tax contributions and immediate Roth conversions are a great savings strategy for high-income earners.

The drawbacks

However, these benefits come with some drawbacks, the most noticeable being that any converted amount is considered ordinary income. When tax season starts the following year, you will owe taxes on these amounts, which either have to come from your wallet or retirement account, depending on the type of account the conversion occurred in.

The second drawback is simultaneously one of the benefits previously mentioned: uncertainty around future tax rates. While taxes could increase in the future, they could also decrease after the conversion. Further, many people will earn less in retirement than while working, so they need to consider whether they will genuinely benefit.

Lastly, after-tax IRA contributions are not viable for those with a tax-deferred balance in their IRA plans since the tax code requires one to convert a portion of the pre-tax amounts, eliminating the benefit.

How it works

When doing a Roth conversion, it is essential to understand the US income tax system and to consult with a tax preparer to answer any questions.

Once well-versed, one can determine the difference between their adjusted gross income (AGI) and desired maximum tax rate; the corresponding amount is how much they would convert. Alternatively, one could determine what amount they can afford to pay in taxes and convert the corresponding total amount needed to generate that tax burden.

Suppose an individual is converting after-tax dollars held in a pre-tax account. In that case, no taxes are due on the transaction unless gains were generated using the funds between the time they were deposited and subsequently converted. These profits are taxed as ordinary income for the converted amount if this occurs.

We are here to help

At Lundeen Abrams Advisors, we focus on holistic planning. We regularly help people navigate the various types of investment accounts, are well-versed in the many individual and employer-sponsored plans, and look forward to assisting you soon. If you are considering a Roth conversion, please get in touch with us to set up a time to discuss how such a conversion could fit into your retirement plan.

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