From Traditional to Roth: What to Think About
In the world of retirement planning, few topics generate as much discussion—and confusion—as the Roth IRA conversion. You may have heard about it from friends, read articles about it, or seen financial commentators debate its merits. It is often presented as a powerful financial strategy, but the reality is that it is a complex decision with significant, permanent consequences.
This is not a simple "yes or no" question. A Roth conversion is a specific financial maneuver, and whether it makes sense depends entirely on an individual’s unique financial picture, their projections for the future, and their tolerance for paying taxes today instead of tomorrow.
Our goal here is not to advise you. We cannot and will not make any recommendations. Our purpose is to provide a purely educational overview of what a Roth conversion is and, more importantly, what factors a person needs to consider. This is about building your understanding so you can be a more informed participant in your own financial life.
First, What Is Happening During a "Conversion"?
Before we get into the considerations, let’s establish what we are talking about.
A Traditional IRA is typically (but not always) funded with pre-tax dollars. This means you may get a tax deduction for your contribution in the year you make it. The money grows "tax-deferred," meaning you do not pay taxes on the growth each year. The trade-off is that when you eventually withdraw money in retirement, every dollar (both your contributions and the growth) is taxed as ordinary income.
A Roth IRA is funded with post-tax dollars. You get no upfront tax deduction. The money grows "tax-free," and when you take qualified withdrawals in retirement, you pay no federal (and often state) income tax on any of it—not the contributions, and not the growth.
A Roth conversion is the act of moving funds from a Traditional IRA to a Roth IRA. When you do this, you are effectively taking money that has never been taxed and moving it into an account where it can grow and be withdrawn tax-free forever.
The Central Consideration: The Tax Bill
You cannot move money from a pre-tax account to a post-tax account without settling the score with the IRS.
A Roth conversion is a taxable event. The entire amount you choose to convert from your Traditional IRA is added to your ordinary income for the year in which you make the conversion.
If you convert $50,000, your taxable income for that year increases by $50,000. It is as simple as that. This is not a penalty or a fine; it is simply the payment of the income taxes that were originally deferred. You are choosing to pay the tax now.
This single fact is the engine that drives every other consideration.
What Do I Need to Think About?
Understanding that a conversion triggers a tax bill leads to a series of critical questions.
1. Your Current Tax Rate vs. Your Expected Future Tax Rate This is the theoretical heart of the Roth conversion decision. The entire strategy is a calculation (or, more accurately, an educated guess) about taxes.
The Theory: You are choosing when to pay income tax. You can pay it today, at your current known tax rate, by doing a conversion. Or, you can pay it in the future, at whatever the tax rates are when you retire.
The Question: Do you believe your income tax bracket will be higher in retirement than it is today?
If you are in a low-earning year (perhaps you are in graduate school, starting a business, or between jobs), your current tax rate might be unusually low. In this scenario, paying taxes now on a conversion could be appealing.
Conversely, if you are in your peak earning years, your current tax rate may be the highest it will ever be. Paying a large conversion tax bill at that high rate may be less desirable than waiting until retirement, when your income (and thus your tax bracket) might be lower.
The X-Factor: This is all speculation. You cannot know for certain what your financial situation will be in 20 or 30 years, nor can you know what federal and state tax laws will look like.
2. How Will You Pay the Tax Bill? This is a logistical, but critical, point. When you convert $50,000, you will owe taxes on that $50,000. Where does that tax money come from?
The most common educational guidance is that the tax bill should be paid with funds from outside your retirement accounts—for example, from a checking, savings, or taxable brokerage account.
Why? If you pay the taxes from the conversion money itself, you are losing a significant part of the benefit. First, you are immediately reducing the amount of money that gets to grow tax-free in the Roth IRA. Second, and more importantly, if you are under age 59.5, that money you pull out to pay the tax may not only be taxed, but also be subject to a 10% early withdrawal penalty. This can be a costly mistake.
3. The Impact on Your Entire Tax Picture for the Year That extra income from a conversion does not just exist in a vacuum. It gets added on top of all your other income (salaries, capital gains, etc.) and can have a domino effect.
Tax Brackets: A large conversion can easily "bump" you into a higher marginal tax bracket. This means that some of the converted dollars (and your other income) will be taxed at a higher rate than you might have anticipated.
Phase-Outs: Your new, higher Adjusted Gross Income (AGI) can change your eligibility for other parts of the tax code. It could reduce or eliminate certain tax credits or deductions. For those nearing or in retirement, it can also affect things like how much of your Social Security benefits are taxed or how high your Medicare premiums are.
4. The 5-Year Rules The IRS has specific "5-year rules" for Roth IRAs to prevent people from using them as short-term, tax-free piggy banks. These rules can be confusing.
Rule 1 (Earnings): To withdraw earnings from a Roth IRA tax-free, you must be over 59.5 and your first-ever Roth IRA (any Roth IRA) must have been open for at least 5 years.
Rule 2 (Converted Principal): This is different. Each conversion has its own 5-year clock. If you are under 59.5 and withdraw converted principal within 5 years of that specific conversion, you may have to pay a 10% penalty. This rule is specifically to stop people from converting a Traditional IRA and immediately withdrawing the money to avoid the 10% early withdrawal penalty.
5. The Pro-Rata Rule (A Major Technical Trap) This is arguably the most complex part of the conversion process. If you have ever made non-deductible (post-tax) contributions to any Traditional IRA, you cannot just convert the "post-tax" money and avoid the tax bill.
The IRS treats all of your Traditional, SEP, and SIMPLE IRAs as one single pool of money. Any conversion you make is considered a proportional, or "pro-rata," mix of your pre-tax and post-tax dollars.
For example, if your total IRA pool is $100,000, of which $20,000 is post-tax (non-deductible) and $80,000 is pre-tax (deductible contributions and growth), then 80% of your money is pre-tax. If you decide to convert $10,000, you cannot just convert the post-tax portion. The IRS will rule that 80% of that conversion ($8,000) is taxable, and 20% ($2,000) is a tax-free return of your non-deductible contribution. This calculation can be very complex.
A Final Thought
A Roth conversion is an irreversible financial decision. It is a trade-off: you are accepting a guaranteed, immediate tax bill in exchange for the potential for tax-free income in the future.
This is one of the most individualized and technical decisions in personal finance. It requires a deep dive into your personal tax situation, a clear-eyed look at your future income potential, and a solid understanding of the many rules involved. We hope this educational overview has helped clarify what those considerations are.
This blog post is for educational purposes only and should not be considered tax or investment advice or a recommendation to buy, sell, or convert any securities. All investing involves risk. Westminster Wealth Management does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party. We strongly encourage you to consult with a qualified tax professional to discuss your individual situation.