It’s important to remember that traditional retirement accounts will add to your taxable income in retirement when you tap them for spending. (UBS)

There is a limit on how much you can contribute to Roth accounts each year (see our Savings waterfall worksheet for details), but there is no limit on the amount of tax-deferred assets that you can convert to Roth each year. A reliance on tax-deferred assets could create a “tax time bomb” for your retirement years, when you will be taxed on distributions from those accounts. Roth conversions can help you to reduce your income tax burden in retirement by adding tax-exempt dollars to your balance sheet.

As with Roth contributions, you will need to pay income taxes on any tax-deferred assets that are converted to a Roth account. A full Roth conversion in a single year would be ill-advised, in our view, generating a lot of taxable income that could be taxed at a higher tax rate. Instead, we generally recommend implementing partial Roth conversions—converting a small amount each year—in order to smooth taxable income out across as many years as possible. This approach can help you move taxable income from higher tax brackets to lower tax brackets, and help reduce your lifetime tax burden.

#1: Markets are down. Most diversified portfolios are still recovering from their 2022 losses, with many stock/ bond portfolios trading around 10–15% below their last all-time high. Completing a partial Roth conversion when your account value has fallen allows you to get a “discount” on the tax cost of the conversion. If you had converted $10,000 of your IRA at the beginning of the year, you would have added $10,000 to this year’s taxable income, but any growth from that point would be completely tax-free in retirement.¹ By contrast, if your portfolio is down 10% from its all-time high, you can now convert the same share of your IRA for $9,000—reducing your taxable income by $1,000 and adding $1,000 to your tax-free growth potential. The tax savings would be even greater if your retirement accounts include nondeductible contributions; because your nondeductible contributions have already been taxed, you will only have to pay taxes on any growth that they’ve generated—not on the contributions themselves.

#2: Your taxable income may be higher in the future. What will your taxable income look like in the future? If your estimated future tax rate will be higher than your tax rate in the current year, then completing partial Roth conversions this year may help you save on taxes. If your tax rate will be lower in the future, then keeping assets in a traditional retirement account, and continuing to contribute to traditional IRA and 401(k) accounts, may outweigh the benefits of Roth contributions or conversions. However, it’s important to remember that traditional retirement accounts will add to your taxable income in retirement when you tap them for spending. The more you contribute to traditional retirement accounts, and the more that you grow these assets, the greater your taxable income in retirement will be due to RMDs as well as other taxable withdrawals that you may need to take to fund your retirement spending. Over-investing in traditional IRA and 401(k) assets today may reduce your tax burden today, but actually increase your overall lifetime tax burden and reduce your after-tax wealth in retirement.

#3: Taxes are going higher. According to the US Debt Clock, the US government currently has about $33 trillion of outstanding debt, and another $211 trillion of “unfunded liabilities” in the form of Social Security, Medicare, and other benefits. It’s certainly possible that entitlement reform and spending cuts will be part of the government’s solution to this debt burden, but it’s also highly likely that higher taxes—especially on higher-income Americans—will be a major part of the solution. If the bulk of your wealth is saved in tax-deferred retirement accounts, higher tax rates are likely to have an impact on your after-tax wealth.

Even if Congress doesn't act, income taxes are already poised to go higher starting in 2026, with higher tax rates, shifting tax brackets, and a 40% drop in the standard deduction from 2023 levels. We estimate that a household with $134,000 of taxable income will face a 2026 federal income tax burden of about $18,308 (effective tax rate of 13.7%), which is 31% more federal income tax than they would face using 2023 tax brackets. A portion of this estimated tax increase could be offset by itemized deduction options, and notably some itemized deductions that were removed in the 2017 Tax Cuts and Jobs Act will return in 2026;. For example, the $10,000 cap on state and local tax deductions is set to expire, and the cap on mortgage interest deductions should also revert (the principal value eligible for an itemized mortgage interest deduction was lowered from $1 million to $750,000).

For families who will incur a higher tax burden starting in 2026, implementing a series of partial Roth conversions during the 2023, 2024, and 2025 tax years may help to bring taxable income into lower tax brackets and move more of the portfolio’s growth into a tax-deferred account, thus enhancing its after-tax growth potential.

#4: Roth conversions can enhance your tax diversification. “Tax diversification” helps you to decide how much taxable income and investment income you will have in a given year, allowing you to manage your

tax burden more dynamically throughout retirement and reducing the risk that future increases to tax rates will chip into the value of your retirement assets by spreading your wealth across multiple account types:

Tax-deferred accounts (Traditional IRAs and 401(k)s),

Tax-exempt accounts (Health Savings Accounts, Roth IRAs, and 401(k)s, etc.), and

Taxable accounts

In order to implement a Roth conversion for the 2023 tax year, you will need to take action by year-end—and you should probably start the process as soon as possible to make sure you have time to fully consider your options and beat the year-end rush. It is important to discuss this decision with your financial advisor and tax advisor, incorporating all the specifics of your family's financial circumstances and objectives.

For more, see Time to consider a partial Roth conversion , 20 November, 2023.

¹ You cannot withdraw earnings from your Roth retirement accounts on a tax-free basis until at least five years after your first contribution to a Roth IRA account. The clock starts ticking on 1 January of the tax year when the first contribution was made. Failure to follow the five-year rule can result in paying income taxes and a 10% penalty on any earnings that are withdrawn. Please also note that if you withdraw funds from a retirement account before age 59 ½, the funds may be subject to a 10% tax for an early distribution.

Important note: Tax strategies can be complex. In addition to federal taxes imposed on ordinary income and capital gains, there may be state and local taxes that must be considered before implementing Roth conversion. Also, transaction costs that may apply from buying and selling securities need to be carefully considered. Each investor should consult his or her own tax advisor concerning the tax consequences of any investment strategy they make or are contemplating. UBS does not offer tax advice. Please note that this is not a recommendation to roll over or transfer your retirement assets. We strongly suggest speaking with a financial advisor and tax advisor to determine the best approach for your personal financial situation.