Is a Roth IRA Conversion Right for You? Key Factors to Consider

If you are considering converting funds from a traditional 401(k) or traditional IRA to a Roth IRA, it may be a smart move for minimizing taxes in retirement. However, the advantages may largely depend on your individual financial situation such as your current tax bracket or additional investment accounts.

It’s crucial to understand all the conversion rules and tax implications as well as the benefits involved to determine whether it’s the right move for you. Timing, of conversion and projected distributions, are also factors for consideration.

Conversion benefits

Converting to a Roth IRA means you’ll pay taxes on the converted amount now, but future withdrawals will be tax-free. The conversion can be advantageous if you expect to be in a higher tax bracket in retirement and want to minimize taxable income. Additionally, if you worry that tax rates will be higher in the future, you could lock in the current rate on the conversion. If you have other sources of income in retirement, like a pension or Social Security, drawing down from the Roth IRA could occur later than you think it will.

One strategy is to gradually transfer traditional IRA or 401(k) plan funds to a Roth IRA over several years. This allows you to access your retirement money before age 59 ½ and without the 10% early withdrawal penalty — if you adhere to the “five-year rule” which says you have to wait five years to distribute converted funds.

Roth IRAs are not subject to required minimum distributions (RMDs) at age 73, unlike with traditional IRAs and 401(k) plans. Failing to meet an RMD deadline in a given year can result in a 25% penalty on the shortfall. The year you turn age 73, the deadline for your required minimum distribution (RMD) from tax-deferred retirement accounts will be April 1^st of the following year.

Roth IRAs can be beneficial for your estate plan because they allow your heirs to inherit the accounts tax-free, potentially reducing their tax burden. But note that there are hidden hazards to inheriting an IRA that may have a negative impact on beneficiaries, including a 10-year limit for distributions, potential loss of disability benefits, and access to funds by those you didn’t intend. Consulting with your wealth advisor can help ensure you avoid these pitfalls.

Conversion rules and tax implications

You could find yourself in a higher tax bracket after conversion because the converted funds become taxable income.

For example, a single taxpayer with taxable income (after deductions) of $120,000, might pay an effective tax rate of 22% but additional taxable income of $536,500 or more would boost that rate to 37%.

However, the long-term benefits of tax-free withdrawals may outweigh the immediate tax costs of conversion. Additionally, you may want to confirm whether the state where you reside has income tax and at what rate.

To avoid a 10% penalty for withdrawals of converted funds, you’ll need to wait five years. Therefore, the timing of conversion in relation to your retirement income needs is important. The good news is that during those five years, the converted funds will continue to grow tax-free if left untouched. There is a penalty for withdrawing funds before you reach age 59 ½ which applies only to the earnings.

If your income exceeds the limits for making contributions to a Roth IRA, you can still perform a Roth conversion by using a “backdoor” strategy. The modified adjusted gross income (MAGI) limit for 2025 for single taxpayers is $165,000 and for joint filers it is $246,000. Generally, the backdoor strategy allows you to contribute money to a traditional 401(k) or IRA, take a tax deduction at that time, then convert the funds to a Roth IRA within 60 days and pay income taxes on the converted amount.

You may want to check the details of how your traditional 401(k) plan is structured by your employer to see if it allows in-plan Roth conversions. While this option can make it easier to convert the funds, the same tax implications will apply.

Making a decision

The tax implications of a Roth IRA conversion can be significant if proper planning isn’t done. In addition, it’s important to consider how it might affect your entire financial situation. Simply wanting to do a conversion for tax-free distributions in retirement shouldn’t be the only driving factor in the decision. Timing and additional income resources may trigger the need for other strategies.

Consulting with a financial advisor or tax professional can help you navigate these complexities and determine the best strategy for your situation.

If you’re not a Mercer Advisors client and have specific concerns or questions about how a Roth conversion might impact your taxes, let’s talk.

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