What Is a Roth IRA Conversion?

A Roth IRA conversion transfers funds from a pretax retirement account, such as a traditional IRA or a 401(k), to a Roth Individual Retirement Account. The process requires paying taxes on the funds the year they’re transferred, but future growth and withdrawals are tax-free.

What Are the Pros and Cons of a Roth IRA Conversion?

The following pros and cons of a Roth IRA conversion impact whether a conversion might be right for you:

Pros of a Roth IRA Conversion

• Investment earnings grow tax-free.

• There are no required minimum distributions (RMDs).

• Your tax bills can be reduced in retirement.

Cons of a Roth IRA Conversion

• The converted amount is added to your income.

• You can temporarily be put in a higher tax bracket.

• The conversion can generate a large upfront tax bill.

• Increased income can increase your Medicare premiums.

• The money must remain in the account for at least 5 years to qualify for a tax benefit.

Why Might a Roth IRA Conversion Be Right for You?

A Roth IRA conversion might be right for you under the following circumstances:

• You like the idea of your investment earnings growing tax-free.

• You want the ability to lower your taxable income in retirement.

• You think your tax rate in retirement might be higher than it is now.

• You want to avoid RMDs. 

Why Might a Roth IRA Conversion Be Wrong for You?

A Roth IRA conversion might be wrong for you under the following circumstances:

• You lack the cash to pay the likely tax bill generated by the conversion, or you might need to pay the tax bill with part of the converted amount, which would sacrifice some of the tax-free investment growth.

• You need the money in the next 5 years. 

• The rollover will subject you to a higher marginal tax bracket in the year of the switch.

• You want to avoid being moved into higher Medicare premiums.

How Does a Roth IRA Conversion Work?

The following factors impact how a Roth IRA conversion might financially affect you:

Taxes

A Roth IRA conversion can increase your tax bill in the year the conversion takes place. You’ll need to “give back” any tax breaks you got when you made your traditional IRA or 401(k) contributions:

• The amount you convert and any earnings are taxable as ordinary income.

• The amount you convert could push you into a higher tax bracket.

• Higher income could affect your Medicare premiums, Social Security taxes, and qualifications for tax breaks, such as the additional senior tax deduction or the state and local tax (SALT) deduction.

You might be able to roll over a 401(k), 403(b), or other employer-sponsored retirement account to a Roth IRA if you are no longer working for the company. However, with the traditional-IRA-to-Roth rollover, you likely will trigger a tax bill, unless you’re starting with a Roth 401(k).

Five-Year Withdrawal Rule

If you are under age 59 ½, your Roth IRA conversions and earnings must remain in the account for 5 years before they can be withdrawn tax- and penalty-free. Early withdrawals can result in taxes and penalties of up to 10%.

No Recharacterizations

Once you’ve made a Roth IRA conversion, you cannot move the money into a different retirement account.

No Required Minimum Distributions

Individuals with traditional IRAs must take RMDs once they turn 75, unless they were born before January 1, 1960, in which case the RMDs begin at age 73. Conversely, Roth IRAs don’t have RMDs, which allows the money to keep growing.

No Income Limits

While contributing directly to a Roth IRA depends on your modified adjusted gross income (MAGI), anyone can complete a Roth conversion and continue adding to the account through future conversions.

How Can You Minimize Taxes on a Roth IRA Conversion?

These tips can help you minimize taxes on a Roth IRA conversion:

1. Make conversions in low-income years: Consider making conversions in the years you switched jobs, had a period of unemployment, or didn’t qualify for your usual bonus. Being in a lower tax bracket reduces the cost of the conversion.

2. Convert when the market is down: Periods when the market takes a hit can be best for conversions. You could pay taxes on a smaller balance, then let the money potentially rebound after it is inside your Roth IRA, where it later can be withdrawn tax-free.

3. Convert early in the tax year: Since taxes do not have to be paid in full until the filing deadline, usually in mid-April the following year, converting early in the calendar year gives you more time to pay. However, if you pay estimated taxes, you might have to make payments sooner.

4. Spread conversions over multiple years: Consider pacing conversions annually, called a Roth conversion ladder. Keep in mind you cannot convert only the portion of your balance that wouldn’t be taxed, such as nondeductible contributions.

*This information is for educational purposes only.

Have you completed a Roth IRA conversion, or are you considering it? Let me know in the comments!