Rollover vs. Conversion: What’s the Difference?

Individuals often find the need to move their retirement savings, whether it’s after changing jobs, seeking new investment options, or consolidating accounts. The terms used by financial institutions and the Internal Revenue Service (IRS) describe distinct actions with very different outcomes, particularly concerning taxation. Understanding these rules is an important part of managing long-term savings and ensures you avoid unexpected tax bills or penalties.

The Retirement Account Rollover

A retirement account rollover is the process of moving funds between two retirement accounts that share the same tax treatment. This means moving money from one pre-tax account to another pre-tax account, or from a Roth account to another Roth account. Common examples include transferring a Traditional 401(k) to a Traditional IRA or a Roth 401(k) to a Roth IRA. A properly executed rollover is not a taxable event because the tax status of the funds does not change.

The most straightforward method is the direct rollover, also known as a trustee-to-trustee transfer. In this scenario, the financial institution holding your old retirement account sends the money directly to the institution managing your new account. The funds never pass through your personal bank account, which simplifies the process and eliminates tax risks.

The second method is an indirect rollover, which is more complex. With an indirect rollover, your former plan administrator sends you a check for the value of your account. From the date you receive the funds, you have 60 days to deposit the full amount into a new, eligible retirement plan. A complication of this method when moving funds from an employer plan like a 401(k) is that the plan is required to withhold 20% of the distribution for federal income taxes.

To complete a tax-free indirect rollover, you must deposit the entire original distribution amount, including the 20% that was withheld. This requires using personal funds to make up for the withheld portion, which can be refunded when you file your annual tax return. Failing to deposit the full amount within 60 days will result in the undeposited portion being treated as a taxable distribution, and if you are under age 59 ½, it may also be subject to a 10% early withdrawal penalty.

The Retirement Account Conversion

A retirement account conversion is a transaction where you move funds from a pre-tax retirement account, such as a Traditional IRA or Traditional 401(k), into a post-tax Roth IRA. Unlike a rollover between like-taxed accounts, a conversion is a taxable event. The entire amount you convert is added to your ordinary income for the tax year in which the conversion occurs.

The tax liability is a direct consequence of changing the funds’ tax status from tax-deferred to tax-exempt. For example, if you are in the 22% federal income tax bracket and you convert $20,000 from a Traditional IRA to a Roth IRA, you will owe an additional $4,400 in income taxes for that year. The primary motivation for a conversion is that once the money is in the Roth IRA, it grows and can be withdrawn in retirement completely tax-free.

A complication arises if you have made both deductible (pre-tax) and non-deductible (post-tax) contributions to any of your Traditional IRAs. In this situation, the IRS pro-rata rule applies, which prevents you from only converting the non-deductible basis to avoid taxes. Instead, any conversion is considered a proportional mix of your pre-tax and post-tax dollars from all your aggregated Traditional, SEP, and SIMPLE IRAs.

The calculation for the taxable portion of the conversion must be reported on IRS Form 8606, Nondeductible IRAs. This form tracks your total basis in non-deductible IRA contributions to ensure that you are not taxed twice on the same money.

Factors Influencing Your Decision

Your expected income tax rate in the future compared to your current rate is a primary factor. If you anticipate being in a higher tax bracket during retirement, performing a Roth conversion now could be advantageous. This allows you to lock in the current tax rate, and all future growth and withdrawals will be tax-free. Conversely, if you expect your income and tax rate to be lower in retirement, a rollover that defers the tax liability may be the more sensible option.

Your ability to pay the resulting tax bill from a conversion is another consideration. The funds used to pay the income tax on a Roth conversion should come from a non-retirement source, such as a savings account. Using money from the converted amount itself reduces the principal that can be invested for tax-free growth. If you are under age 59 ½, using a portion of the converted funds to pay the tax bill would be considered an early distribution, subjecting that amount to a 10% penalty.

The length of time until you plan to retire also plays a role. A longer time horizon provides more years for the assets in a Roth IRA to grow tax-free. This extended period of tax-free compounding can help to offset the upfront cost of the conversion tax, making a conversion more appealing for those with many years left before retirement.

Estate planning goals can also influence the decision. Roth IRAs and designated Roth accounts within employer plans are not subject to Required Minimum Distributions (RMDs) for the original account owner. This allows the entire balance to continue growing tax-free for your lifetime.

Traditional IRAs, however, require owners to begin taking distributions once they reach a certain age. The SECURE 2.0 Act set the age at 73 for those born between 1951 and 1959, and it will increase to 75 for those born in 1960 or later. Converting from a traditional account to a Roth IRA can eliminate these lifetime distributions, providing a potentially larger, tax-free inheritance for beneficiaries.