As the calendar turns to a new year, so does the opportunity—and urgency—to make strategic financial decisions that could impact your 2025 income tax return. Amid the hustle of holiday preparations and year-end checklists, don’t overlook an impactful financial decision you can make before December 31 – a Roth conversion. Before the ball drops on New Year’s Eve, it’s worth evaluating whether a Roth conversion belongs on your year-end financial checklist.
Roth IRAs offer tax-free benefits in retirement when certain conditions are met, in addition to tax-deferred accumulations. Anyone can choose to convert existing traditional IRA assets to a Roth IRA, but conversion comes with a cost—you pay income taxes on the amount you convert in the calendar year you convert. Therefore, it is important to review your situation with your tax professional before year end to see if a Roth conversion strategy makes sense for you this year.
Is a Conversion Right for You?
Conversion can be advantageous if you think you will be in the same or higher income tax bracket in retirement and you:
- Desire tax-free retirement income (after five years and age 59 ½)
- Want more choice and tax efficiency when generating your retirement income – you choose which “bucket” of assets you withdraw from and when,
- Want to reduce or possibly eliminate required minimum distributions during your lifetime, or
- Desire tax-free income for your heirs after your death.
How to Choose IRA Assets for Conversion
When you complete a Roth conversion, you get to choose the amount, the timing, and which assets to convert. For some, converting an entire IRA might make sense. For others, converting smaller amounts systematically over a number of years may be more beneficial. In addition, if you have certain assets in your IRA that are currently undervalued, you can also selectively choose those assets to convert to help manage the tax cost of the conversion.
Understanding Qualified Distributions and the 5-Year Rule
For a Roth IRA to provide tax-free earnings, you must satisfy a 5-year rule and be at least age 59 ½.[1] Here’s how the 5-year rule works:
- There is one 5-year rule that applies across all Roth IRAs you own to determine if earnings withdrawn are qualified (tax free).
- If you make Roth salary deferral contributions through your workplace retirement plan, the 5-year rule applies separately to the plan.
- Conversion also triggers a separate 5-year rule that is used to determine if the 10% penalty applies when you are younger than age 59 ½ and you withdraw converted balances in the first five years following a conversion.
Back-Door Roth Strategy for High Earners
Another conversion strategy that could warrant a review before the end of the year is a back-door Roth conversion. For high income individuals, who have no other IRAs and are ineligible to make annual Roth IRA contributions, it enables the funding of a Roth IRA while limiting the cost of the conversion. The back-door Roth strategy involves two steps:
- First, you make non-deductible (after-tax) contributions to a traditional IRA. IRA contributions are limited to $7,000 ($8,000 if you are age 50 or older) in 2025.
- Next, you convert them to a Roth IRA.
The tax cost for the conversion is then limited to the amount earned in the traditional IRA between the date of the contribution and conversion, which if done quickly may be nothing or a very small amount.
The back-door Roth strategy is less tax efficient if you have other existing IRA balances because a special pro-rata tax calculation would apply when you convert. It includes all pre-tax balances in any traditional IRA, SEP or SIMPLE IRAs you own even if they are not the accounts being converted. This is sometimes referred to as the “cream in the coffee” rule.
Funding a Roth IRA through the “back door” can be beneficial not only because it gives individuals the ability to utilize Roth IRAs to save when their income would otherwise prevent it, but also because it starts the 5-year holding period for future tax-free distribution of earnings. This is particularly helpful if you have been contributing to a designated Roth account in your 401(k), 403(b) or 457(b) where there are no income limits that prevent your contributions. At your retirement or separation from service, balances in your plan’s Roth accounts can be rolled over to a Roth IRA. Because those rollovers don’t carry the holding period from the plan into the Roth IRA, you avoid having to start the 5-year rule over again by rolling into a pre-existing Roth IRA where the 5-year time period has already begun.
Talk to Your Advisor Before You Convert
Don’t wait. Talk to your financial advisor and your tax professional today to see if a Roth conversion fits your holiday financial year-end checklist.
IMPORTANT DISCLOSURES: The information provided is based on internal and external sources that are considered reliable; however, the accuracy of this information is not guaranteed. This piece is intended to provide accurate information regarding the subject matter discussed. It is made available with the understanding that Benjamin F. Edwards is not engaged in rendering legal, accounting or tax preparation services. Specific questions on taxes or legal matters as they relate to your individual situation should be directed to your tax or legal professional.
[1] Qualified Roth distributions are also available after five years if used for a first-time home purchase (limited to $10,000), due to disability, or after your death when paid to a beneficiary.