How to Convert an IRA to a Roth IRA

A Roth IRA conversion is the process of moving funds from a pre-tax retirement account, such as a traditional, SEP, or SIMPLE IRA, into a post-tax Roth IRA. This transaction allows for future qualified distributions to be tax-free. Unlike contributions, there are no income limits preventing an individual from performing a conversion. The central consideration in this process is that the conversion itself is a taxable event. The amount of pre-tax money moved is added to your gross income in the year the conversion takes place, which can have significant financial implications.

Tax Consequences of a Roth Conversion

The primary tax consequence of a Roth IRA conversion is the immediate recognition of income. Any pre-tax funds moved from a traditional IRA to a Roth IRA are added to your ordinary income for that tax year. This additional income is then taxed at your marginal tax rate. For example, if an individual in the 24% federal tax bracket converts $50,000 of pre-tax traditional IRA assets, that $50,000 is added to their other income, resulting in an additional $12,000 in federal income tax. This increase in adjusted gross income (AGI) can also affect other areas of your tax return, potentially phasing out certain deductions and credits.

An important element of Roth conversions is the pro-rata rule, which applies when you have both pre-tax and after-tax (nondeductible) funds in your IRAs. The IRS requires that any conversion be comprised of a proportional mix of these two types of money. To calculate this, you must aggregate the value of all your traditional, SEP, and SIMPLE IRAs. You cannot isolate and convert only the after-tax basis to avoid taxes.

To illustrate the pro-rata calculation, consider an individual with a total of $100,000 across all their traditional IRAs as of December 31 of the conversion year. Within that total, they have a $20,000 basis from previous nondeductible contributions. This means 20% of their total IRA funds are post-tax, and 80% are pre-tax. If they decide to convert $30,000 to a Roth IRA, the conversion is treated as 80% taxable and 20% tax-free. Consequently, $24,000 is added to their taxable income, and the remaining $6,000 is a tax-free return of their nondeductible basis.

A 10% early withdrawal penalty may apply if you withdraw converted amounts from your Roth IRA within five years of the conversion, should you be under the age of 59 ½. This five-year holding period is distinct for each conversion event. The clock for any specific conversion begins on January 1 of the year in which the conversion was made. This rule is designed to prevent individuals from using a Roth conversion as a way to access retirement funds early without penalty.

Information and Forms for the Conversion

Before initiating a conversion, you must gather specific financial data. You need the total value of all your traditional, SEP, and SIMPLE IRAs, determined as of December 31 of the conversion year. You also need the total basis of all nondeductible contributions you have ever made to your traditional IRAs. Finally, you must decide on the exact dollar amount you wish to convert.

After you complete a conversion, your financial institution will send you Form 1099-R in January of the following year. This form reports the gross amount of the distribution from your traditional IRA. The code in Box 7 indicates the type of transfer, such as code ‘G’ for a direct conversion or codes ‘2’ or ‘7’ for an indirect 60-day rollover.

You will file Form 8606, Nondeductible IRAs, with your tax return. This IRS form is used to calculate the taxable portion of a Roth conversion. Part II of the form walks you through the pro-rata calculation. The result from this form determines the amount of income to report on Form 1040, where the total distribution is reported on Line 4a and the taxable amount on Line 4b.

The Conversion Process

There are three primary methods for moving the assets. A trustee-to-trustee transfer is a common approach where you instruct the financial institution holding your traditional IRA to move the funds directly to a Roth IRA. This process is seamless, as the money never passes through your hands, minimizing the risk of error.

Another method is the 60-day rollover, or indirect conversion. You request a distribution from your traditional IRA, and the custodian sends you a check. You then have 60 days from the date you receive the funds to deposit them into a Roth IRA. If you miss the 60-day deadline, the entire distribution becomes fully taxable and may be subject to a 10% early withdrawal penalty if you are under 59 ½. The IRS permits only one indirect rollover across all of an individual’s IRAs within any 12-month period.

A third option is a same-trustee conversion. If you plan to keep your Roth IRA at the same financial institution that holds your traditional IRA, you can request that the firm redesignate the traditional IRA assets as Roth IRA assets. This is an internal transfer that involves minimal paperwork and is handled entirely within one company.

Post-Conversion Reporting and Tax Payment

After the conversion, you must pay the associated tax. One choice is to have taxes withheld directly from the funds during the conversion process. This approach is discouraged because the withheld amount is considered a distribution, not part of the conversion. If you are under age 59 ½, that withheld money could be subject to both ordinary income tax and a 10% early withdrawal penalty.

A better approach is to pay the tax liability from a separate source, such as a savings or brokerage account. You can do this by making quarterly estimated tax payments using Form 1040-ES. This helps you cover the tax liability as you incur it. Alternatively, you can pay the full tax amount when you file your return, but if you owe more than $1,000, you may face an underpayment penalty from the IRS.