Roth IRAs are extremely valuable tools for saving for retirement, and thanks to law changes that took effect in 2010, anyone can now convert a traditional IRA to a Roth IRA. But it's important to understand the income tax aspects of converting traditional IRA assets to a Roth, and you want to avoid any potential for penalties or other adverse tax impacts that can result. By running an analysis and then converting the right way, you can make the most of the Roth IRA opportunity.

What to think about with Roth conversions

In considering whether to convert your IRA to a Roth, you'll need to think about several things. First, the most important thing about a Roth conversion is that you'll generally have to pay income tax currently on the amount that you convert. That gets taxed at your current-year tax rate. However, once you pay those taxes, any future growth within the Roth is tax-free. You won't have to pay taxes on withdrawals from the converted Roth IRA once you retire.

Roth IRA sign.

Image source: Getty Images.

What that generally boils down to is that if your tax bracket right now is low compared to where you think it'll be when you retire, then converting makes a lot of sense. If your tax bracket is high, however, then converting might not make as much of a difference.

Other factors also play a role. The younger you are, the longer your nest egg has to grow tax-free in a Roth, and so the more it makes sense to convert. Converting also gives you some flexibility in terms of early withdrawals from the account.

Running the Roth numbers

It takes a lot of math and analysis to run scenarios but, fortunately, there are calculators that can do the trick. The one below offers a great amount of detail, running through alternative situations to find which one works the best.


* Calculator is for estimation purposes only, and is not financial planning or advice. As with any tool, it is only as accurate as the assumptions it makes and the data it has, and should not be relied on as a substitute for a financial advisor or a tax professional.

Take two examples. In the first, you're 55 and have a $100,000 IRA. You want to start getting income from your Roth at 65, and you expect to live 30 years and get an 8% pre-tax return on savings. Your current tax bracket is 15%, but you expect that to climb to 25% once you retire. When you run the numbers, you'll find that with the Roth conversion, you'll end up with a total nest egg of $216,000 and monthly income of almost $1,600. If you don't convert, you'll have a higher-value nest egg of $245,000, but you'll have to pay taxes on withdrawals. That gives you an after-tax income of just $1,375.

Take another example in which everything is the same except your expected retirement tax bracket is just 15%. Under that scenario, the total nest egg if you don't convert grows to $260,000, producing $1,650 in monthly income after taxes. That compares to the same roughly $1,600 as above if you do convert. As you can see, the disparity isn't that great, showing that time can work on your side even if you expect lower taxes in retirement.

A couple things to watch

The examples above assume that you're able to pay Roth conversion taxes with money outside the Roth. If you can't and instead have to use the Roth account itself to pay the taxes, then you'll not only see your retirement nest egg drop, but you'll also suffer possible penalties if you're younger than age 59 1/2. Even worse, you'll have less money in the Roth to grow on a tax-free basis. It's better to use money outside the Roth to pay any taxes due.

Also, make sure that you're careful in actually doing the conversion transaction. The best thing to do is to have money directly transferred from the traditional IRA to the Roth IRA. That way, you'll never get retirement assets in your hands even temporarily to tempt you, and you won't run the risk of goofing up an intended rollover and causing an even bigger tax mess.

Roth IRAs are extremely valuable, but converting isn't the right choice for everyone. By using the calculator above to run the numbers, you can find good answers to guide your decisions about whether to do a Roth conversion.