Woman wondering if she should convert to a Roth IRA.
Planning for retirement

Taxes now or later? IRA answers from an advisor.

A financial advisor shares insights on the pros and cons of Roth conversions and how to tell if a conversion would benefit you.
Commentary by
8 minute read
February 10, 2023
Planning for retirement
Roth IRAs
Health care

A lot of my clients come to me with questions about converting to a Roth IRA. Moving money from a traditional IRA to a Roth IRA (often referred to as the "taxes now or later" debate) comes with some complex issues. It's also irreversible, so it's understandable that many investors struggle to make the best choice. Here are answers to some common questions.

What's the difference between a traditional and a Roth IRA?

The biggest difference between a Roth IRA and a traditional IRA is the timing of the taxes you pay. Contributions to traditional IRAs are usually tax-deductible, but withdrawals in retirement are taxable. Roth IRAs function in the opposite way. Contributions to Roth IRAs aren't tax-deductible, but qualified withdrawals in retirement are tax-free. Essentially, it's a matter of paying taxes now (Roth) or later (traditional).

Who should consider a conversion?

I always start by looking at my client's financial situation and goals. Here are a few scenarios where converting from a traditional to a Roth may be beneficial:

  • You're retired or have recently reduced your income (meaning you're now in a lower income tax bracket).
  • You have concerns that tax rates will go up for you in the future.
  • You consider tax efficiency a key goal.
  • You want to leave a tax-free inheritance to your heirs.

What are the tax benefits of a Roth conversion?

We talk a lot about diversifying the assets in your portfolio, but it's also helpful to diversify your tax strategy. For some, a Roth conversion can offer:

  • Protection against uncertainty. No one can predict what tax rates will be, or how they'll change over time. Current tax rates and estate tax exemption amounts expire December 31, 2025. You can hedge your tax risk by having money in a broader range of taxable and tax-advantaged accounts. That way, you'll minimize the risk that changes to the tax code will diminish the value of your investments. 
  • Tax-free withdrawals in retirement. Unlike withdrawals from a traditional IRA, qualified Roth IRA withdrawals are generally tax-free. If you're under age 59½ at the time of the withdrawal, you may be subject to tax and penalty, unless an exception applies.
  • Tax-free growth. Roth IRAs don't have required minimum distributions (RMDs) during your lifetime, so your money can stay in your account and keep growing tax-free.
  • Tax-free inheritance. When your beneficiaries inherit IRA assets, in most cases they are required to distribute those assets within 10 years of your passing. For traditional IRA assets, those distributions will be considered taxable income, while assets in a Roth IRA are typically tax-free.

If you're ready to get started, we offer tutorials to make the process easy.

Should I withhold taxes on a Roth conversion?

The amount you convert to a Roth IRA is taxable, but you don't have to withhold taxes during the conversion. You can opt to pay taxes on a Roth conversion when you file your tax return; however, if the tax bill is large enough, you could be subject to late payment penalties. Review your overall tax situation with a tax advisor and make estimated tax payments as necessary, ideally from non-IRA assets.

Paying taxes from nonretirement sources allows you to maximize the benefit of the conversion by having more dollars grow in the Roth rather than being used to cover the tax bill.

When isn't a conversion a good fit?

One of the biggest drawbacks to a conversion is the tax bill. If you're still earning significant income, you're most likely in a higher tax bracket now than you will be during retirement. In that case, you're probably better off keeping your money in a traditional IRA, since the conversion could come with significant taxes. 

Consider when you'll need the money as there's a 5-year holding period on money that's part of a Roth conversion. Your capital gains tax rates may also be affected. Capital gains tax rates are tied to income, so the amount you convert could push you into a higher tax bracket.

What else could a conversion affect?

Health care is an important part of the Roth conversion puzzle. If the conversion would push your modified adjusted gross income (MAGI) above a certain threshold, your Medicare Part B premiums could go up. Converting too much could also cause a larger percentage of your Social Security benefits to be taxed. If you're under age 65 and not yet eligible for Medicare, and no longer covered by an employer plan, then you likely are looking at Affordable Care Act (ACA) Marketplace plans for your health insurance needs. ACA plans provide premium tax credits to families whose income falls between 100% and 400% of the federal poverty level* (FPL). However, there's a "subsidy cliff" at the 400% poverty level, meaning if you make more than that, you'll have to pay more. These subsidies can equate to hundreds or possibly thousands of dollars a year, so disqualifying yourself through Roth conversions can cost you. 

There's some good news, though. The American Rescue Plan Act (ARPA) of March 2021 provided some relief, capping insurance premiums at 8.5% of household income. The Inflation Reduction Act of 2022 has extended this relief through the 2025 tax year. This gives those on Marketplace plans an opportunity to convert to a Roth IRA without losing all their health insurance subsidies because of the temporary increase in income.

What are backdoor Roth conversions?

Roth IRA contributions come with income limits, but there is a process to convert to a Roth IRA even if your income is too high.

First, you make a nondeductible contribution to a traditional IRA, which has no income limits. Then you move the money into a Roth IRA using a Roth conversion.

Some of this applies to my situation, but how can I be sure a Roth conversion is right for me?

Roth conversions are permanent, so if you're still unsure, consult with an advisor. We can help you make a choice that's right for your goals. 

I became an advisor because I wanted to help people navigate financial challenges. Every time I guide someone toward a decision that benefits them, I know I've accomplished something worthwhile. No matter the dollar amount, I've got your back.

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*The FPL is issued by the Department of Health and Human Services each year and determines eligibility for certain programs and benefits. Amounts vary according to your family size. Source: https://www.healthcare.gov/glossary/federal-poverty-level-fpl/.

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You may want to consult a tax advisor about your situation. Neither Vanguard nor its financial advisors provide tax and/or legal advice. This information is general and educational in nature and should not be considered tax and/or legal advice. Any tax-related information discussed herein is based on tax laws, regulations, judicial opinions, and other guidance that are complex and subject to change. Additional tax rules not discussed herein may also be applicable to your situation. Vanguard makes no warranties with regard to such information or the results obtained by its use, and disclaims any liability arising out of your use of, or any tax positions taken in reliance on, such information. 

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