When to convert to a Roth IRA

Once you hit retirement, your Roth IRA account will be your most valuable money because of its tax-free structure. So when should you make the switch from a regular IRA to a Roth?

Issei Kato/Reuters/File
One-hundred US dollar bills at an exchange booth in Tokyo. When you convert a traditional IRA to a Roth, you’ll have to pay some income taxes upfront, but the long-term savings will more than make up for it under the right circumstances.

If you’ve been planning ahead for retirement, you probably have an IRA (or a 401(k) that will eventually be rolled over to an IRA). You probably know that you received a tax deduction when you contributed to that IRA. You probably also know that when you start taking money out of that IRA you will owe income taxes.

But did you know you can convert that IRA to a Roth IRA?

Roth IRAs grow tax-free, and withdrawals are tax-free as long as they are qualified. Once you hit retirement, your Roth IRA account will be your most valuable money because of that tax-free structure.

When you convert a traditional IRA to a Roth, you’ll have to pay some income taxes upfront: Any pretax amount you convert must be included in your taxable income for the year of the conversion. But don’t let this deter you from converting when there are real advantages to doing so. Here are five times to consider converting:

1. When you are in a low tax bracket

I have a client who retired recently, and we have strategically decided to delay starting hisSocial Security benefits. He will have no income other than interest and dividends in 2016. Since he is married, we expect to be able to convert around $20,000 of his IRA to a Roth IRA, and he will not owe any taxes because personal exemptions and the standard deduction will reduce his taxable income to zero. This is the proverbial tax grand slam in that he received a tax deduction for his IRA contributions, the proceeds grew tax-deferred, and he ultimately avoided paying any federal and state taxes at conversion!

2. When you don’t need the money and plan to leave it to your kids

If you’ve done an adequate job of saving and it’s extremely unlikely you will need all of your savings for retirement, consider a Roth conversion as a gift to your kids. This makes even more sense if your kids (or grandkids) are in a higher tax bracket than you are. You pay the taxes now, and the kids inherit an account that is completely tax-free and continues to grow tax-free over the rest of their lives.

3. When your investments are temporarily low

In the 2007-2009 recession, the stock market dropped nearly 50% — but it made up the losses within five years. Smart investors who recognized that they have a long time horizon took advantage of that temporary decline. Imagine that your IRA started at $100,000, then dropped to $50,000, and you converted to a Roth IRA at that point, paying income taxes on $50,000. A few years later, the $50,000 in the converted Roth IRA was once again worth $100,000, but now is completely tax-free. You avoided paying income taxes on $50,000!

4. When you believe tax rates will go up

I’m not in the business of guessing where tax rates will go. Some people think, based on who gets elected and who controls Congress, that federal tax rates might go up at some point. If you think that’s true, then converting to a Roth IRA and paying taxes now, rather than higher rates later, might make sense.

5. When you want to reduce the value of your estate for tax purposes

This is a more remote scenario, since the vast majority of estates are exempt from estate tax. But for those with a large enough estate, it may make sense to convert to a Roth IRA during your lifetime. Converting means that you will reduce the value of your estate because you are paying taxes now instead of later. A smaller estate means a lower estate tax bill. Remember that with a traditional IRA, some of that money already “belongs” to the government because it will be paid in taxes upon withdrawal, but all of the money in your IRA will included when calculating the value of your estate. In effect, with a traditional IRA you could be paying estate taxes on the government’s money. Paying taxes on taxes is usually a bad thing.

Learn more about Steven on NerdWallet’s Ask an Advisor.

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