When Is it Useful to Convert a Regular IRA to a Roth?

Roth conversions would seem to be the holy grail of retirement investing. Once you've taken deductions on contributions to a traditional IRA and watched those funds increase, it seems a neat trick to then move that money into an account that is not taxed at retirement and from which you never need to take a distribution. Tax wise, it is useful to convert a traditional IRA to a Roth if you believe your tax rate during retirement will be higher than it is while you are working or if you want to leave the IRA to your kids.

Retirement Is Decades Away

When you convert from a traditional IRA to a Roth, you have to pay income tax on the money you convert. That can amount to a pretty penny if you transfer a large sum. If you're also in a high tax bracket, the pain can be even worse. However, if you plan to leave the converted funds in the account, giving them decades to grow, you're more likely to recover from the tax bite.

Higher Retirement Tax Bracket

Traditional IRAs are taxed at withdrawal. While Roth IRA contributions are taxed, distributions at retirement are tax-free. Many people expect their taxable income -- and therefore their tax bracket -- to peak during their working years and drop, along with their income, at retirement. However, if, because of an inheritance, for example, you anticipate paying higher income tax rates in your later years, converting your traditional IRA holdings to a Roth may prove prudent.

Wealth Transfer

If you do expect an inheritance, or expect to have accumulated property or investments to support you during your golden years, you may not need the money in your IRA. You might choose instead to pass your IRA money along to your children. In that case, converting is an excellent notion. A Roth IRA does not require that you ever take distributions. Moreover, you can keep putting money in it for as long as you live. These features make the Roth a quality tool for transferring wealth. Say you transfer $100,000 from a traditional IRA to a Roth at age 35. You continue to fund the Roth at the maximum yearly contribution level until you pass away at 75. You leave the Roth to your spouse who treats it as her own, continuing to add money to it and witness the account's steady growth. When your spouse passes on, and the Roth finally goes to your kids, the accumulated sum may reach seven figures.

Partial Conversions

Your conversion decision doesn't have to be all or nothing. It is possible to move part of your money from a traditional IRA to a Roth, if for example, you want to leave only a portion of your IRA money to your kids. To ease the pain of the conversion tax, you can even decide to make a series of partial conversions until you have moved all your traditional IRA money into a Roth. The latter strategy might also prove useful if an all-at-once conversion would push you into a higher tax bracket for the year.