Moving Money From a Traditional IRA to a Roth IRA

Moving funds from a traditional Individual Retirement Arrangement (IRA) to a Roth IRA is known as a Roth conversion. This financial maneuver repositions assets from an account where contributions may have been tax-deductible to one that offers tax-free growth and withdrawals in retirement. The core trade-off is paying income tax on the converted amount now for the benefit of tax-free distributions later.

Key Information for a Roth Conversion

The primary tax implication of a Roth conversion is that any pre-tax money moved from a traditional IRA becomes taxable income in the year the conversion occurs. This includes deductible contributions and any investment earnings. The converted amount is added to your annual income, which can affect your overall tax liability for the year.

The pro-rata rule prevents individuals from selectively converting only after-tax funds to avoid taxation. For a conversion, the IRS mandates that all of an individual’s traditional, SEP, and SIMPLE IRAs are treated as a single, aggregated account. You cannot isolate and convert only nondeductible contributions if you also hold pre-tax funds. The taxable portion of any conversion is determined proportionally based on the ratio of pre-tax to after-tax money in all your aggregated IRAs.

For example, if you have $95,000 in pre-tax funds and $5,000 in after-tax funds across all your traditional IRAs, your total IRA balance is $100,000. In this scenario, 95% of your total IRA funds are pre-tax. Consequently, if you decide to convert $20,000 to a Roth IRA, 95% of that amount, or $19,000, would be considered taxable income. Only $1,000 would be a tax-free return of your after-tax contributions.

Two five-year rules are important to understand with Roth IRAs. The first rule determines if distributions of investment earnings are tax-free. For earnings to be qualified, the first Roth IRA must have been opened for at least five tax years and the owner must be over age 59 ½.

A separate five-year holding period applies to each conversion to determine if a 10% penalty applies to the withdrawal of principal. This penalty applies if you are under age 59 ½ and withdraw the converted funds within five years. After age 59 ½, you can withdraw converted principal at any time without penalty.

A Roth conversion is an irreversible action. It is no longer possible to undo or “recharacterize” a Roth conversion. Once you move the funds from a traditional IRA to a Roth IRA, the decision is final, making upfront tax planning important.

Calculating the Conversion Tax

Estimating the tax liability from a Roth conversion begins with a clear accounting of your existing IRA assets. The first step is to determine your basis, which consists of all after-tax, or nondeductible, contributions you have made to all of your traditional, SEP, and SIMPLE IRAs. This figure represents the portion of your IRA funds that you have already paid tax on.

Next, you must calculate the total value of all your traditional, SEP, and SIMPLE IRAs. This is the aggregate fair market value of all such accounts, not just the value of the single account you plan to convert from. The valuation should be determined as of the date you execute the conversion.

This calculated taxable amount is then added to your other income for the year, such as wages and investment gains, to determine your adjusted gross income (AGI). Adding a significant sum from a conversion can push you into a higher marginal tax bracket. It is advisable to have sufficient funds in a separate, non-retirement account to cover the resulting tax liability, as using IRA funds to pay the tax can trigger additional taxes and penalties.

The Roth Conversion Process

The most common method is a direct conversion, also known as a trustee-to-trustee transfer. You instruct the financial institution holding your traditional IRA to move the assets directly to a new or existing Roth IRA. The money is never in your possession, which simplifies the process and reduces the risk of error.

An alternative method is an indirect conversion, which operates under the 60-day rollover rule. You request a distribution from your traditional IRA and receive a check. You then have a 60-day window to deposit the full amount into a Roth IRA. If you miss the deadline, the IRS treats the entire amount as a taxable distribution and may also apply a 10% early withdrawal penalty if you are under age 59 ½.

If you hold both your traditional and Roth IRAs at the same financial institution, the process is often simpler. This is known as an in-house conversion. This functions as an internal transfer of assets and can often be completed online through the institution’s web portal.

Tax Reporting Requirements

After completing a Roth conversion, you must report the transaction to the IRS on your annual tax return. Your financial institution will send you Form 1099-R. This form reports the total amount moved from your traditional IRA, showing the gross distribution and a code that indicates the nature of the distribution.

The primary document for reporting the conversion is Form 8606, Nondeductible IRAs. Part I of the form is used to report any new nondeductible contributions you made to your traditional IRA for the tax year. This is where you establish or add to your after-tax basis.

Part II of Form 8606 is where you calculate the taxable amount of the conversion. The form guides you through the pro-rata calculation, using the total basis from Part I and the total value of all your traditional, SEP, and SIMPLE IRAs. This form officially documents the taxable and nontaxable portions of the funds you moved.

Finally, you transfer the figures from Form 8606 to your main tax return, Form 1040. The total amount of the conversion is reported on the line for IRA distributions, and the taxable portion is reported on the corresponding line for taxable amounts. This ensures the income from the conversion is properly included in your gross income.