Roth IRA Conversion

What Is a Roth IRA Conversion?

A Roth IRA conversion involves the transfer of retirement assets from a traditional, simplified employee pension (SEP), or SIMPLE IRA, or from a defined-contribution plan such as a 401(k), into a Roth IRA. While the account owner has to pay income tax on the money they convert, they will be eligible to make tax-free withdrawals from the account in the future.

Key Takeaways

  • A Roth IRA conversion involves transferring retirement funds from a traditional-type IRA or 401(k) into a Roth account.
  • The account holder must pay tax on the money they convert, but their withdrawals from the Roth account can be tax-free in the future.
  • This strategy can make sense if the person believes they will be in a higher tax bracket in the future and that they'll save money by paying taxes now rather than later.
  • Roth conversions completed after Dec. 31, 2017, cannot be turned back into traditional IRAs, as was previously the case.

How a Roth IRA Conversion Works

A conversion may be accomplished in several ways.

  1. A direct rollover from a defined-contribution plan, such as a 401(k) or 403(b), if you're leaving your job or if you left an account behind with a former employer. The plan's administrator can send the money to your new account or give you a check made out to the new account that you can then deposit.
  2. A trustee-to-trustee transfer, in which the assets are directly transferred from the financial institution (or trustee) where your traditional IRA is held and the one where your new Roth IRA will be held. If you wish, that can be the same financial institution (a same-trustee transfer).
  3. A 60-day rollover, in which the money is paid to you and you then deposit all or part of it in a Roth IRA within 60 days.

The first two methods are generally the safest and most practical. With a 60-day rollover, if you fail to deposit the money within that time, it will be treated as taxable income and you may also face a 10% tax on early distributions if you're under age 59½. In addition, 60-day rollovers (unlike the other two methods) can be subject to 10% tax withholding. So if you're rolling over a $10,000 IRA, you'd only receive $9,000 and if you wanted to put the full $10,000 into your Roth account, you'd have to come up with $1,000 from another source.

Note that Roth conversions completed after Dec. 31, 2017, can no longer be recharacterized—in other words, turned back into a traditional IRA—as was previously the case.

When Roth IRA Conversions Make Sense

The major advantage of converting a traditional IRA or 401(k) into a Roth IRA is the ability to make tax-free withdrawals at some point in the future. That can be particularly appealing if you expect to be in a higher marginal tax bracket in retirement. While most people's incomes (and tax brackets) decline in retirement, that isn't always the case. For example, if you have a lot of money in traditional IRAs, your required minimum distributions (RMDs) starting at age 72 could boost your income substantially.

In addition, there is no predicting what the tax brackets and tax rates will be in the future. If taxes go up by the time you retire, converting a traditional IRA and taking the tax hit now rather than later could make sense in the long run.

Another consideration involves estate planning. Roth IRAs—unlike other types of retirement accounts—are never subject to required minimum distributions during your lifetime. So if you don't need the money for living expenses, you can allow it to grow undisturbed and leave it to your heirs someday. If the account beneficiary is your spouse, they won't have to take RMDs either. Other types of beneficiaries, such as children, will eventually have to take distributions, but as long as they follow the rules, those distributions will be tax-free.

The Build Back Better Act (H.R. 5376), passed by the House in 2021, would make changes to existing rules around IRA rollovers for wealthier taxpayers. But as of March 2022, Senate passage looks unlikely and the fate of these proposals is unclear.

Example of a Roth IRA Conversion

By timing your conversion carefully, and possibly spreading it over several years, you may be able to ease the tax burden.

Suppose, for example, that you're single, will earn a taxable income of $80,000 this year, and have $100,000 in a traditional IRA that you'd like to convert into a Roth. Based on your taxable income, your highest marginal tax bracket is currently 24%. Because the 24% bracket ends at $170,050, you could convert up to $90,050 this year ($170,050 minus $80,000) and pay no more than 24% tax on the money. If you were to convert the entire $100,000, the remaining $9,950 would be taxed at the next highest tax bracket of 32%.

In this case, you could save some money by spreading your conversion over two tax years.

What Is the Purpose of a Roth IRA Conversion?

The main reason people convert traditional IRAs or other retirement accounts into Roth IRAs is so they can enjoy tax-free income in retirement. They also have the flexibility to not make withdrawals if they don't need the money. That's because Roth IRAs, unlike traditional ones, aren't subject to required minimum distributions during the owner's lifetime.

How Much Tax Do You Pay on a Roth IRA Conversion?

The amount of tax you have to pay on a Roth IRA conversion will depend on your tax bracket at the time and how much money you convert. It is taxed as ordinary income.

How Do I Avoid Taxes on a Roth IRA Conversion?

You can't avoid taxes altogether, but you may be able to reduce the tax burden by converting just enough money to stay under the limit for the next marginal tax bracket. For that reason, it can pay to spread the conversion over several tax years. Another potential way to reduce your taxes is by doing the conversion in a year when your other income is unusually low, such as after a layoff. 

What Is a Backdoor Roth IRA Conversion?

A backdoor Roth IRA is a colloquial term for a technique wealthier taxpayers can use to get around the income limits for opening a Roth IRA. Because traditional IRAs have no income limits on eligibility, high-income taxpayers can contribute to traditional IRAs, then convert those accounts into Roth IRAs. There have been moves in Washington to eliminate this practice, but it remains legal as of March 2022.

The Bottom Line

A Roth IRA conversion allows you to turn a traditional IRA or 401(k) plan account into a Roth. You'll have to pay income tax on the money you convert, but you'll be able to take tax-free withdrawals from the Roth account in the years to come. Roth IRA conversions make the most sense if you expect to be in a higher tax bracket after you retire or if tax rates in general rise significantly in the future.

Article Sources
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  2. Internal Revenue Service. "Rollovers of Retirement Plan and IRA Distributions."

  3. Internal Revenue Service. "IRA FAQs."

  4. Internal Revenue Service. "Publication 590-B (2020), Distributions From IndividualRetirement Arrangements (IRAs)."

  5. Internal Revenue Service. "IRS Provides Tax Inflation Adjustments for Tax Year 2022."

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