Should You Convert a Traditional IRA to a Roth IRA?

A Roth IRA conversion involves moving funds from a traditional, SEP, or SIMPLE IRA into a Roth IRA. This financial maneuver is permanent and cannot be reversed. The core of this transaction is a trade-off: you pay income taxes on the converted amount now for the benefit of qualified tax-free withdrawals in the future. The process itself is a taxable event, treating the converted funds as income in the year the conversion occurs.

Key Factors Influencing the Conversion Decision

A primary consideration is the comparison between your current income tax rate and your expected tax rate during retirement. If you anticipate being in a higher tax bracket in your later years, converting now might be advantageous. This is common for younger professionals whose income is likely to increase. By paying taxes on the conversion at today’s lower rate, you avoid paying potentially higher taxes on distributions when you retire.

Conversely, if you are at your peak earning years and expect your income and tax bracket to be lower in retirement, a conversion may be less beneficial. This requires a projection of future income, potential changes to federal and state tax laws, and your anticipated retirement lifestyle.

The ability to pay the conversion tax with funds from outside your retirement account is a significant factor. Using money from a checking, savings, or brokerage account to cover the tax bill preserves the full principal of your converted IRA, allowing it to grow tax-free. Paying the tax from the converted funds reduces your retirement savings from the start. This action is treated as a withdrawal and could be subject to a 10% early withdrawal penalty if you are under age 59½.

Your investment time horizon affects the effectiveness of a conversion. A longer period before you need the funds provides more time for tax-free growth to compound and make up for the initial tax payment. If you plan to withdraw the money within five years, a conversion may not be beneficial as there is insufficient time for the tax-free earnings to overcome the upfront tax cost.

For those with estate planning goals, a Roth IRA offers advantages. Beneficiaries of a Roth IRA can receive distributions tax-free, which contrasts with inherited traditional IRAs where beneficiaries must pay income tax on withdrawals. This makes the Roth IRA an efficient vehicle for transferring wealth.

Consider the impact of Required Minimum Distributions (RMDs). Traditional, SEP, and SIMPLE IRA owners must begin taking taxable RMDs at a certain age defined by the IRS. Roth IRA owners, however, are not subject to RMDs during their lifetime, allowing the money to continue growing tax-free.

Understanding the Tax Consequences

When you convert funds from a traditional IRA to a Roth IRA, the converted amount is added to your adjusted gross income (AGI) for that year. This money is taxed at your ordinary income tax rates, not capital gains rates. A substantial conversion can push you into a higher marginal tax bracket, increasing your overall tax liability for the year.

An important element of the tax calculation is the pro-rata rule. This rule applies if you have both pre-tax and after-tax (nondeductible) contributions across all your traditional, SEP, and SIMPLE IRAs. The IRS views all your non-Roth IRAs as a single account for this calculation, meaning you cannot convert only the after-tax money to avoid taxes.

To illustrate the pro-rata rule, imagine you have a total of $100,000 across all your traditional IRAs. Of this amount, $80,000 came from pre-tax contributions and earnings, and $20,000 came from after-tax, nondeductible contributions. This means 20% of your total traditional IRA balance is after-tax money. If you decide to convert $50,000 to a Roth IRA, the pro-rata rule dictates that 20% of that conversion ($10,000) is considered a tax-free return of your after-tax contributions. The remaining 80% ($40,000) is taxable income.

Beyond federal taxes, you must also account for state income taxes. Most states with an income tax treat the converted amount as taxable income. Failing to factor in state tax liability can lead to an unexpected tax bill.

The Conversion Process

The most common method is a trustee-to-trustee transfer, where you instruct the financial institution holding your traditional IRA to move the funds directly to a Roth IRA. This process avoids you taking possession of the money and minimizes the risk of error.

A similar option is a same-trustee transfer, which occurs when converting funds within the same financial institution. You direct the custodian to relabel the traditional IRA assets as Roth IRA assets. This is often the simplest method, involving minimal paperwork.

The third method is an indirect conversion, also known as a 60-day rollover. You receive a check from your traditional IRA and have 60 days to deposit it into a Roth IRA. This method is the riskiest because failing to complete the deposit within the 60-day window means the entire amount is treated as a taxable distribution and may be subject to a 10% early withdrawal penalty.

After choosing your method, contact your IRA custodian. They will provide the necessary forms and guide you through their specific procedures.

When you initiate the conversion, you must also plan how to pay the resulting tax liability. You can make estimated tax payments to the IRS or increase the tax withholding from your paycheck to cover the additional income and avoid underpayment penalties.

Post-Conversion Rules and Considerations

After completing a Roth IRA conversion, you must be aware of specific rules that govern withdrawals. The IRS has established two five-year rules that can affect your access to the funds and help you avoid unexpected taxes and penalties.

The first rule applies to withdrawals of your converted funds. Each conversion has its own five-year holding period. If you withdraw any taxable portion of your converted funds before this five-year period has passed, you may be subject to a 10% early withdrawal penalty, even if you are over age 59½. This rule is designed to prevent using a conversion to access retirement funds early without penalty.

A separate five-year rule applies to the earnings generated within your Roth IRA. For earnings to be withdrawn tax-free, the Roth IRA account must have been open for at least five years. This clock starts on January 1 of the tax year for which you made your first contribution to any Roth IRA. These two rules operate independently.

You must report the conversion on your tax return. In the year following the conversion, your IRA custodian will send you Form 1099-R, reporting the distribution from your traditional IRA. You must then file Form 8606, Nondeductible IRAs, with your federal tax return to report the conversion and calculate its taxable amount.