Should You Convert a Traditional IRA to a Roth IRA?

A Roth IRA conversion is the process of moving funds from a traditional, SEP, or SIMPLE IRA into a Roth IRA. The core of this decision is a tax trade-off: you must pay ordinary income tax on the pre-tax funds you move now, in exchange for tax-free qualified withdrawals in the future.

This strategy also allows investors with incomes too high for direct contributions to establish a Roth IRA. A conversion is a permanent action; the Tax Cuts and Jobs Act of 2017 eliminated the ability to reverse it, so a careful evaluation of your financial situation is necessary before proceeding.

Key Financial Considerations for Conversion

A conversion is most advantageous if you expect to be in a higher tax bracket during retirement than you are now. By converting, you pay taxes at your current, lower rate and avoid paying higher taxes on withdrawals later. This requires comparing your current income tax rate to your expected rate in retirement.

Several factors can influence your future tax rate. Your income may increase, or future changes in tax legislation could result in higher rates. Other retirement income sources, like pensions or 401(k)s, will also contribute to your taxable income in retirement, potentially pushing you into a higher bracket.

You should plan to pay the conversion tax with funds from outside the IRA, such as a savings account. This preserves the full converted amount, allowing the entire balance to grow tax-free. Using IRA funds to pay the tax reduces the principal that can generate future growth. If you are under age 59 ½, funds withdrawn from the IRA to pay taxes may also be subject to a 10% early withdrawal penalty.

The time until you need the funds is also a factor. A longer time horizon, such as 10 years or more, provides a greater opportunity for the account’s tax-free growth to overcome the initial tax cost. If retirement is imminent, there may not be enough time for the investment to recover from the taxes paid.

Traditional IRAs have required minimum distributions (RMDs) starting at age 73, which are taxable and increase your income regardless of your need for the money. Roth IRAs do not have RMDs for the original owner. This allows your investments to continue growing tax-free for your entire lifetime if the funds are not needed.

For estate planning, a Roth IRA offers advantages. Beneficiaries inherit a Roth IRA and can take qualified distributions tax-free. In contrast, an inherited traditional IRA is taxable to the heirs, who must often deplete the account within 10 years. Converting allows you to prepay the income tax on behalf of your heirs.

Converting a traditional IRA to a Roth IRA increases your adjusted gross income (AGI) for that year. A higher AGI can have other financial consequences. It could cause a larger portion of your Social Security benefits to become taxable or lead to higher Medicare Part B and Part D premiums through the Income-Related Monthly Adjustment Amount (IRMAA).

Calculating the Tax Impact

To calculate the tax impact, you must first determine the taxable portion of the conversion. Any amount from a traditional IRA funded with pre-tax contributions is added to your ordinary income for the year. This additional income is taxed at your marginal tax rate.

If you have made both pre-tax and after-tax (non-deductible) contributions to any of your traditional, SEP, or SIMPLE IRAs, the calculation is more complex. The IRS applies the pro-rata rule, which prevents you from converting only the non-deductible, after-tax funds. Instead, any conversion is considered a proportional mix of your pre-tax and after-tax money.

To use the pro-rata rule, you must aggregate the balances of all your traditional, SEP, and SIMPLE IRAs as of December 31 of the conversion year. You also total all non-deductible contributions made to these accounts. The percentage of your total IRA assets that is non-deductible is the same percentage of your conversion that will be tax-free.

For a numerical example, assume you have a total of $100,000 across all your traditional IRAs on December 31. Your records show that you have made $20,000 in non-deductible contributions over time. This means 20% of your total IRA balance is after-tax money. If you decide to convert $50,000 to a Roth IRA during that year, the pro-rata rule dictates that 20% of that conversion, or $10,000, is a tax-free return of your basis. The remaining 80%, or $40,000, is considered pre-tax money and must be added to your taxable income for the year.

After determining the taxable portion of your conversion, you can estimate the tax bill by applying your marginal federal and state income tax rates. Remember that the added income could push you into a higher tax bracket, meaning some of the converted amount may be taxed at a higher rate. Using tax software or consulting a tax professional can provide a more precise estimate.

The Conversion Process

There are three primary methods for converting funds. The first is a trustee-to-trustee transfer, where you instruct your financial institution to move funds directly to a Roth IRA. This is a straightforward method where you never take possession of the money. A similar method is a same-trustee conversion, which involves simply re-designating assets from a traditional to a Roth IRA at the same institution.

Another method is an indirect conversion, or 60-day rollover. You withdraw funds from your traditional IRA and have 60 days to deposit them into a Roth IRA. This method is risky; if you miss the 60-day deadline, the withdrawal is treated as a taxable distribution and may incur a 10% early withdrawal penalty if you are under age 59 ½.

To initiate a conversion, contact your IRA custodian. They will provide the necessary paperwork asking for your account information, the amount to convert, and the transfer method. Completing and submitting these forms sets the conversion in motion.

Post-Conversion Rules and Reporting

Two separate 5-year rules apply to Roth IRAs. The first governs the withdrawal of earnings. For earnings to be withdrawn tax-free, your first Roth IRA must have been open for at least five years, and you must be over age 59 ½. This clock starts on January 1 of the tax year of your first contribution to any Roth IRA.

A separate 5-year rule applies to each conversion amount. This rule determines if the converted principal can be withdrawn penalty-free before age 59 ½. Each conversion starts its own five-year holding period. If you withdraw converted principal before its five-year period has passed and are under 59 ½, that amount is subject to a 10% penalty.

Proper tax reporting is mandatory. Your traditional IRA custodian will issue Form 1099-R, which reports the total amount distributed. You must file Form 8606 with your tax return to report the conversion and calculate the taxable amount, especially if the pro-rata rule applies.

You must pay the income tax liability for the year the conversion occurred. This can be done by increasing your paycheck withholding or by making quarterly estimated tax payments to the IRS. Failing to account for this tax can result in an underpayment penalty on your annual return.