Roth Conversions: What They Are & The 3 Things Federal Employees Need To Know

With all the recent talk of Roth conversions in the media and on the hill, many federal employees are asking what the heck is a Roth conversion, and where do I get one? Simply stated, a Roth conversion refers to the process of moving some or all of your tax-deferred retirement savings from accounts like the traditional TSP, an IRA, or 401(k) into what is typically a Roth IRA. Now, most of you are likely aware of the tax benefits of a Roth account (if you’re not read this article), and completing a Roth conversion is pretty straightforward, but this strategy isn’t suitable for everyone, and there are certainly some trapdoors you want to avoid. So, before you pull the trigger on your conversion, here are the 3 things all federal employees should know about Roth conversions.

1. You’ll Have A Tax Bill

Tax considerations are critical for Roth conversions. Although a Roth conversion allows you to move money out of your tax-deferred account and into a Roth account without incurring any penalties, you’ll owe taxes on all the pre-tax funds transferred. The key here is that you’re moving your money from a “tax me later” account to a “tax me now” account, which only makes sense if you believe you’re currently in a lower tax bracket than you’ll be in the future.

While projecting future tax rates can be a bit of a gamble since no one knows what will happen in Washington, as a federal employee, you can fairly accurately estimate your retirement income. So, if you expect your income to be higher in the future, accelerating income and initiating a Roth conversion could make sense since you’d be paying taxes while in a lower tax bracket.

For instance, let’s say, Bob, a federal employee about to retire, projects that his FERS pension and the savings he’s stocked away will be enough to live on for the first few years of retirement. This period when he is not receiving Social Security or taking regular TSP distributions could be a great time to convert some of his tax-deferred retirement savings into a Roth IRA.

Here is a word of caution to Bob and others considering Roth conversions; Because a Roth conversion will increase your taxable income in the year of conversion, you want to ensure that you don’t inadvertently push yourself into a higher tax bracket and forfeit the potential tax savings this strategy can deliver. In addition to paying more federal and potentially state taxes, initiating a large conversion could have some unintended consequences, such as increasing your Medicare premiums. Hence, although there isn’t a limit on the amount you can convert, it rarely makes sense to convert your entire retirement account; thus, partial conversions are generally preferable.

2. You’ll Need Cash

Though timing your conversions to coincide with years when your tax bracket is lower will reduce your overall tax bill, you’ll still have a bill that will need to be paid. Thus, another important factor when considering a Roth conversion is ensuring you can afford the taxes that will need to be paid without pulling the funds from your retirement account.

You shouldn’t pull money out of your retirement account to pay the tax bill because you don’t want to lose the tax-free growth. Meaning the opportunity cost could outweigh the potential tax savings.

Breaking down your tax obligation into manageable bite-sized chunks is another reason why most federal retirees who employ this strategy will find partial conversions done over several years more appealing than converting a lump sum.

3. Roth IRAs Are Different

The third point to understand when considering a Roth conversion is that Roth IRAs have different rules. Here are two critical ways that the rules differ: First, while federal employees who separate from service in the year they turn 55 or later (age 50 for SCEs) are eligible to take penalty-free distributions from their TSP, such distributions are generally not allowed from an IRA until age 59 ½. Therefore, take care because you’ll lose this benefit if you move your TSP funds to a Roth IRA.

Note: Both the TSP and IRA have exceptions that allow you to take penalty-free withdrawals (substantially equal periodic payments, death, disability, etc.).

The second way Roths differ from your TSP or IRA is that they are subject to the “five-year rule.” Which requires you to leave your converted funds in the account for at least five years before withdrawing them; if you’re under 59 ½, otherwise, you would be subject to the 10% early withdrawal penalty. Additionally, any earnings that were withdrawn before meeting the 5-year rule would be subject to taxation.

Hence, if you might need the funds you plan on converting within 5 years, a Roth conversion is likely not a good strategy for you.

Final Thoughts

Although Roth conversions can be a remarkable tax planning tool, they are not suitable for everyone. And the decision to initiate a conversion should be contingent on your personal and financial situation and should factor in the tax consequences of a conversion, the cash needed to pay the taxes due, and the rules governing Roth IRAs. Because the tax ramifications of a Roth conversion can be significant and often have multiyear effects that are irreversible, I highly encourage everyone federal employee who is considering this strategy to consult with a qualified financial planner.


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Author: Jose Armenta, MsBA, CFP®, ChFC®, EA

Jose Armenta is a CERTIFIED FINANCIAL PLANNER professional who specializes in helping federal employees get the most out of their federal benefits. Jose's experience serving federal employees provides him with valuable insight into the unique financial planning needs of federal employees.