Should I Convert My IRA to a Roth?

A Roth IRA conversion moves funds from a traditional, SEP, or SIMPLE IRA into a Roth IRA. This changes the savings from tax-deferred to potentially tax-free. With a traditional IRA, contributions are often tax-deductible and withdrawals are taxed in retirement. A Roth IRA uses after-tax contributions, allowing for tax-free qualified withdrawals of contributions and earnings.

The conversion itself is a taxable event. The amount you convert is added to your ordinary income for that year, which can push you into a higher tax bracket. There are no income limits that prevent an individual from performing a conversion, making it a strategy available to all taxpayers.

Key Factors for Your Conversion Decision

The decision to convert depends on your anticipated tax situation now versus in retirement. If you expect to be in a higher tax bracket during your retirement years, converting now allows you to pay taxes at your current, lower rate. Conversely, if you anticipate your income and tax rate will be lower in retirement, it may be better to keep the funds in a traditional IRA.

You must consider your ability to pay the income tax generated by the conversion. The most effective strategy is using funds from a non-retirement source, like a savings account, to cover the tax liability. Paying the tax with money from the IRA reduces the amount moved into the Roth account. If you are under age 59.5, using IRA funds to pay the tax could be treated as an early withdrawal, subjecting that portion to a 10% penalty.

The length of time until you plan to begin withdrawals is another factor. A longer investment horizon provides more time for the tax-free growth within the Roth IRA to compound and outweigh the initial tax cost. If you anticipate needing the funds within five years, the benefits of converting are reduced.

Estate planning objectives can influence the decision. Beneficiaries who inherit a Roth IRA can receive distributions tax-free, a substantial advantage compared to an inherited traditional IRA where distributions are taxable. This makes the Roth IRA a useful tool for transferring wealth.

A conversion can help manage future Required Minimum Distributions (RMDs). Traditional IRAs require you to start taking taxable withdrawals annually once you reach a certain age. Individuals born between 1951 and 1959 must begin at age 73, while the age is 75 for those born in 1960 or later. Roth IRAs have no RMD requirements for the original owner, allowing funds to continue growing tax-free.

Understanding the Tax Consequences

The pro-rata rule applies if you have made both pre-tax (deductible) and after-tax (non-deductible) contributions to any of your traditional, SEP, or SIMPLE IRAs. The IRS requires you to aggregate all your non-Roth IRAs to determine the taxability of a conversion. You cannot choose to convert only the after-tax basis, as any conversion is considered to contain a proportional mix of your pre-tax and after-tax dollars.

For example, consider an individual with two traditional IRAs totaling $100,000, of which $30,000 (30%) is after-tax basis. If this person converts $50,000 to a Roth IRA, they cannot designate it as coming solely from the after-tax funds. Instead, 30% of the conversion ($15,000) would be a tax-free return of basis, while the remaining 70% ($35,000) would be taxable income. This calculation is reported to the IRS.

Beyond federal income tax, the converted amount is also subject to state income tax. State tax laws vary, with some having high income tax rates and others having none. You should factor in your state’s tax treatment of retirement income when evaluating the total cost of a conversion.

The Conversion Process

To begin a conversion, contact the financial institution that holds your traditional IRA. If you do not already have a Roth IRA, you will need to open one. The firm can provide the necessary paperwork and guide you through its procedures.

There are three primary methods to execute a conversion. The most common is a trustee-to-trustee transfer, where funds move directly between institutions. If your accounts are at the same firm, this is a same-trustee transfer where the assets are simply redesignated. The third method is an indirect rollover, where you receive a check and have 60 days to deposit it into a Roth IRA.

The indirect rollover method carries more risk. If you miss the 60-day deadline, the entire distribution may be treated as a taxable withdrawal. Because of this potential complication, direct transfer methods are preferred.

After you authorize the transaction, the process is typically completed within a few business days. Your financial institution will send confirmation statements and, at year-end, the required tax forms reflecting the distribution.

Post-Conversion Rules and Reporting

After a conversion, two distinct five-year rules govern withdrawals. The first rule applies to the withdrawal of earnings. For any withdrawal of earnings to be tax-free and penalty-free, you must be at least 59.5 years old, and five years must have passed since January 1 of the tax year of your first contribution to any Roth IRA.

A separate five-year rule applies to each conversion. If you are under age 59.5 and withdraw converted amounts within five years of the conversion, the withdrawal may be subject to a 10% early withdrawal penalty. Each conversion has its own five-year holding period that begins on January 1 of the year it was made.

Proper tax reporting is necessary in the year of the conversion. Your financial institution will send Form 1099-R, which reports the distribution from your traditional IRA. You must file Form 8606, Nondeductible IRAs, with your federal tax return to report the conversion to the IRS and calculate the taxable amount, especially if the pro-rata rule applies.