If you believe your tax rate is lower now than it will be when you start taking withdrawals, a conversion may look promising because you'll pay conversion taxes while you're in a lower tax bracket and enjoy tax-free Roth IRA withdrawals later (when the higher tax bracket won't matter).
But if you believe your tax rate is higher now than it will be when you start taking withdrawals, a conversion could cost you more in taxes now than you'd save with tax-free withdrawals later.
So what do you do? It may help to "diversify" your taxes—in other words, pay some of the taxes now (when you're still building your retirement savings) and save some for later (when you need that money to cover expenses in retirement).
A Roth IRA can be a great place to stash your retirement savings. Unlike a traditional IRA, you won't have to pay income tax on the money you withdraw or be required to take a minimum amount from your account each year after you reach a certain age.
However, these retirement accounts are available to just about everyone: you can't contribute to a Roth IRA if your income exceeds the limits set by the IRS. But you can convert a traditional IRA into a Roth—a process that's sometimes referred to as a "backdoor Roth IRA." Read on to learn about Roth IRA conversion rules that you may be able to take advantage of.
Key Takeaways
- You can convert all or part of the money in a traditional IRA into a Roth IRA.
- Even if your income exceeds the limits for making contributions to a Roth IRA, you can still do a Roth conversion, sometimes called a "backdoor Roth IRA."
- You will owe taxes on the money you convert, but you'll be able to take tax-free withdrawals from the Roth IRA in the future.
- Roth IRA conversion rules are set by the IRS and must be followed in order to avoid taxes and penalties.
- Roth IRA conversions may not make as much sense for individuals nearing retirement, as it may be more advantageous to simply pay taxes over time via traditional IRA withdrawals.
Roth IRA Conversion Rules
Converting all or part of a traditional IRA to a Roth IRA is a fairly straightforward process. The IRS describes three ways to go about it:
- A rollover, in which you take a distribution from your traditional IRA in the form of a check and deposit that money in a Roth account within 60 days
- A trustee-to-trustee transfer, in which you direct the financial institution that holds your traditional IRA to transfer the money to your Roth account at another financial institution
- A same-trustee transfer, in which you tell the financial institution that holds your traditional IRA to transfer the money into a Roth account at that same institution
Of these three methods, the two types of transfers are likely to be the most foolproof. If you take a rollover and, for whatever reason, don't deposit the money within the required 60 days, you could be subject to regular income taxes on that amount plus a 10% penalty. The 10% penalty tax doesn't apply if you are over age 59½.
Whatever method you use, you will need to report the conversion to the IRS using Form 8606: Nondeductible IRAs when you file your income taxes for the year.
If the value of your retirement account has dropped, that could be a good time to convert to a Roth IRA because the tax impact will be less onerous than when your account is worth more.
Tax Implications of Converting to a Roth IRA
When you convert a traditional IRA to a Roth IRA, you pay taxes on the money you convert in order to secure tax-free withdrawals as well as several other benefits, including no required minimum distributions, in the future.
Roth IRAs are available to people who earn a specific amount of money, which means if you make more than the earnings threshold, you're not eligible for a Roth IRA. Unfortunately, you're stuck paying taxes on withdrawals from your retirement account when you finally retire. Or, maybe you're not.
Many retirement savers not eligible for a Roth IRA do a conversion to reduce the taxes that they pay in retirement by moving their money from a traditional IRA to the Roth variety. This strategy is known as a Roth conversion. It's also called a backdoor Roth IRA conversion because it allows people not ordinarily eligible for a Roth IRA due to their income to set up a Roth—sneaking in the back door, so to speak.
Key Takeaways
- A Roth individual retirement account (Roth IRA) conversion lets you turn a traditional IRA into a Roth IRA.
- Roth IRA conversions are also known as backdoor Roth IRA conversions.
- There’s no upfront tax break with a Roth IRA, but contributions and earnings grow tax free.
- You’ll owe ordinary income tax on any amount that you convert.
- Plan to pay the taxes from another account so that you don't reduce your converted retirement account's earning power.
What Is a Roth IRA Conversion?
A Roth IRA conversion occurs when you move funds from a traditional IRA, simplified employee pension (SEP) IRA, or savings incentive match for employees (SIMPLE) IRA into a Roth IRA. In 2010, the federal government began allowing people to convert their accounts from traditional IRAs into Roth IRAs, regardless of their income.
In general, people can invest in a Roth IRA only if their modified adjusted gross income (MAGI) falls below a specific limit. For example, if you’re married filing jointly and earn $214,000 or more per year in 2022 ($228,000 in 2023), you can’t invest in a Roth IRA. Single and head of household filers, and married filing separately, have a cutoff of $144,000 ( $153,000 in 2023).
But there are no income limits for conversions.
Sound good? It can be. But, like most investment choices, a Roth IRA conversion has advantages and disadvantages.
Advantages of a Roth IRA Conversion
A key benefit of doing a Roth IRA conversion is that it can lower your taxes in the future. While there’s no upfront tax break with Roth IRAs, your contributions and earnings grow tax free.
In other words, once you pay taxes on the money that goes into a Roth IRA, you’re done paying taxes, provided that you take qualified distributions. While it’s impossible to predict what tax rates will be in the future, you can estimate if you’ll be making more money and, therefore, be in a higher bracket.
Another perk to a Roth IRA is that you can withdraw contributions (not earnings) at any time, for any reason, generally tax free. Still, you shouldn’t use your Roth IRA as a bank account. Any money you take out now will never get the opportunity to grow. Even a small withdrawal today can have a big impact on the size of your nest egg in the future.
Moving to a Roth IRA also means you won’t have to take required minimum distributions (RMDs) on your account once you reach age 72. If you don’t need the money, you can keep your money intact and pass it to your heirs.
Important
You must pay the tax bill on your conversion in the year that the conversion takes place.
Making the Case for a Roth Conversion
A Roth conversion makes sense in specific situations. For example, say that you have a traditional IRA that you've been paying into for years. You've finally retired and have more income from your savings and investment account withdrawals than you believed you would have.
You and your spouse also will begin drawing social security in one year. You realize that your taxable income will increase—and your tax bracket along with it. Your IRA withdrawals will then be taxed at a higher rate.
You decide to convert your IRA to a Roth IRA because doing so would reduce your overall tax burden due to a higher tax bracket.
Disadvantages of a Roth IRA Conversion
The most significant disadvantage of converting to a Roth IRA is the whopping tax bill. If, for example, you have $100,000 in a traditional IRA and convert that amount to a Roth IRA, you would owe $24,000 in taxes (assuming your effective tax rate is 24%). Convert enough, and it could even push you into a higher tax bracket.
Of course, when you do a Roth IRA conversion, you risk paying that big tax bill now when you might be in a lower tax bracket later. While you can make some educated guesses, there’s no way to know what future tax rates (or your income) will be.
Yet another common issue that many taxpayers face is contributing the full amount and then converting it when they have other traditional IRA, SEP, or SIMPLE IRA balances elsewhere.
When this happens, you’re required to compute a ratio of the monies in these accounts that have been taxed already vs. the aggregate balances that have not been taxed (in other words, all tax-deferred account balances for which you deducted your contributions vs. those for which you didn’t). This percentage is counted as taxable income. It’s complicated, so you should get professional help.
Another drawback: If you’re younger, you must keep the funds in your new Roth IRA for five years and ensure that you’ve reached age 59½ before taking out any money. Otherwise, you’ll be charged not only taxes on any earnings but also a 10% early distribution penalty (unless you qualify for the few exceptions).
Making the Case Against a Roth Conversion
While a Roth conversion may seem to be a great idea at first, there are situations in which you wouldn't want to convert. For instance, say you're 55 and earning the most you ever have. You believe that the next five years will be your peak earning years, so you want to take advantage of it and keep contributing.
However, you're in a higher tax bracket because you're making more, so you'll end up paying more taxes if you convert. In this case, you might want to wait until you're in a lower tax bracket or not convert at all.
Remember, you must also wait five years after converting before beginning withdrawals. So if you think you'll need to access the funds before that, the conversion might not be a good idea.
Roth Conversion Pro and Cons
Pros
Contributions and earnings grow tax free.
You can withdraw contributions at any time, for any reason, tax free.
You don’t have to take required minimum distributions.
Those normally ineligible for a Roth IRA can convert savings to a tax-free pool of cash.
Cons
You must pay potentially substantial tax on the conversion in the year that it occurs.
You may not benefit if your tax rate is lower in the future.
You must wait five years to take penalty-free withdrawals, even if you’re already age 59½.
Figuring taxes can be complicated if you have other traditional, SEP, or SIMPLE IRAs that you’re not converting.
Paying the Tax Bill on a Roth IRA Conversion
If you do a Roth IRA conversion, how and when will you pay that tax bill?
The money in your IRA has grown tax deferred, which means it hasn't been taxed yet. When you convert a traditional IRA to a Roth, the money in your account is considered additional income for that year. It's possible that that added income could push you into a higher tax bracket for that year. Be sure to consider that when planning.
However, you shouldn't use funds from the account to pay the taxes. The best way to pay the tax bill is to use money from a different account—such as from your savings or by cashing out a certificate of deposit (CD) when it matures. Here’s why:
Paying your taxes from your IRA funds instead of from a separate account will erode your future earning power. Say you convert a $100,000 traditional IRA. After paying taxes, you deposit only $76,000 into the new Roth IRA. From then on, you’ll miss out on all the money you would have earned on the original balance.
While $24,000 may not seem like a lot, compounding interest means that money could grow to almost $112,000 over 20 years at an interest rate of 8%. That’s a lot of money to forgo to pay a $24,000 tax bill.
Use the tax brackets for 2022 and 2023 below as you consider converting to a Roth IRA.
2022 Tax Brackets Tax RateSingle Filer Married Filing SeparatelyMarried Filing Jointly Head of Household10%$10,275 or less$10,275 or less$20,550 or less$14,650 or less12% $10,276 to $41,775$10,276 to $41,775$20,551 to $83,550 $14,651 to $55,90022% $41,776 to $89,075$41,776 to $89,075$83,551 to $178,150 $55,901 to $89,05024% $89,076 to $170,050 $89,076 to $170,050$178,151 to $340,100 $89,051 to $170,05032% $170,051 to $215,950 $170,051 to $215,950$340,101 to $431,900 $170,051 to $215,95035% $215,951 to $539,900 $215,951 to $323,925$431,901 to $647,580 $215,951 to $539,90037% Over $539,900 Over $323,925Over $647,580 Over $539,900
Source: Internal Revenue Service
2023 Tax Brackets Tax RateSingle Filer Married Filing SeparatelyMarried Filing Jointly Head of Household10%$11,000 or less$11,000 or less$22,000 or less$15,700 or less12% $11,001 to $44,725$11,001 to $44,725$22,001 to $89,450 $15,701 to $59,85022% $44,726 to $95,375$44,726 to $95,375$89,451 to $190,750 $59,851 to $95,35024% $95,376 to $182,100 $95,376 to $182,100$190,751 to $364,200 $95,351 to $182,10032% $182,101 to $231,250 $182,101 to $231,250$364,201 to $462,500 $182,101 to $231,25035% $231,251 to $578,125 $231,251 to $346,875$462,501 to $693,750 $231,251 to $578,10037% Over $578,125 Over $346,875Over $693,750 Over $578,100
Source: Internal Revenue Service
What Is the Downside of a Roth Conversion?
The most significant disadvantage to converting a traditional IRA to a Roth is that you could have a large tax bill when you complete the conversion.
Is a Roth Conversion a Good Idea?
It depends on your financial situation. It might be a good idea if you're in a position where the taxes you pay at conversion are lower than the total amount of taxes you'd pay on traditional IRA withdrawals. It could also make sense if you simply want to cut the taxes that you pay once you're in retirement.
How Do I Avoid Taxes on a Roth IRA Conversion?
There is no way to avoid paying taxes on a Roth conversion. However, you can lower your tax burden by timing the conversion right. For example, you might convert in a year when your taxable income is lower than it has been. Or, when your current tax bracket has enough room for the added income that the conversion represents (so that you don't get pushed into a higher tax bracket).
The Bottom Line
A Roth IRA conversion can be a very powerful tool for your retirement. If you believe that your taxes will rise after you begin withdrawing from your traditional IRA because of increases in marginal tax rates—or because you'll earn more—then a Roth IRA conversion can save you considerable money in taxes over the long term.
In addition, the backdoor strategy makes the Roth accessible to high-earners who normally would be ineligible for a Roth or who cannot move money into a tax-free account by any other means.
However, several conversion drawbacks should be considered. In particular, a potentially big tax bill could be tricky to calculate, especially if you have other retirement accounts funded with pretax dollars.
Therefore, it’s essential to weigh the tax benefits of doing a conversion and consult with a tax advisor about your specific situation.